Stock compensation 2020,Stock-based compensation

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Stock-based compensation September 2020

About this guide

PwC is pleased to offer our updated Stock-based compensation guide. This guide explains the

fundamental principles of accounting for all types of stock-based compensation, including which

arrangements are subject to its scope, measurement date, vesting conditions, expense attribution, and

classification (i.e., liability or equity), as well as the accounting required when awards are modified.

This guide also discusses the unique accounting for nonpublic companies, awards to nonemployees,

employee stock purchase plans and employee stock ownership plans, as well as valuation

considerations. This guide also provides our perspectives on the impact of the accounting guidance on

stock-based compensation plan design, including a summary of employer and employee income tax

considerations.

This guide summarizes the applicable accounting literature, including relevant references to and

excerpts from the FASB’s Accounting Standards Codification (the Codification). It also provides our

insights and perspectives, interpretative and application guidance, illustrative examples, and

discussion on emerging practice issues.

This guide should be used in combination with a thorough analysis of the relevant facts and

circumstances, review of the authoritative accounting literature, and appropriate professional and

technical advice. Guidance on financial statement presentation and disclosure related to stock-based

compensation can be found in PwC’s Financial statement presentation guide (FSP 15).

References to US GAAP

Definitions, full paragraphs, and excerpts from the FASB’s Accounting Standards Codification are

clearly labelled. In some instances, guidance was cited with minor editorial modification to flow in the

context of the PwC Guide. The remaining text is PwC’s original content.

References to other PwC guidance

This guide provides general and specific references to chapters in other PwC guides to assist users in

finding other relevant information. References to other guides are indicated by the applicable guide

abbreviation followed by the specific section number. The other PwC guides referred to in this guide,

including their abbreviations, are:

□ Business combinations and noncontrolling interests (BCG)

□ Derivatives and hedging (DH)

□ Fair value measurements (FV)

□ Financial statement presentation (FSP)

□ Financing transactions (FG)

□ Income taxes (TX)

□ Revenue from contracts with customers (RR)

About this guide

Summary of significant changes

Following is a summary of the noteworthy revisions to the guide since it was last updated in March

2020. Additional updates may be made to keep pace with significant developments.

Revisions made in September 2020

SC 2, Measurement date, vesting conditions, and expense attribution

□ SC 2.3.2.5 was added, including Example SC 2-2 regarding cash loans to employees in the form

of a nonrecourse note secured by the employee’s shares in the employer.

□ Example SC 2-4 was added regarding awards with a performance condition and employer call

right.

□ Example SC 2-14 was added regarding changes to the requisite service period for an award with

a vesting acceleration clause.

□ Example SC 2-21 was added regarding attribution of expense for an award with “front-loaded”

vesting.

SC 5, Employee stock purchase plans

□ SC 5.3.1 was added regarding the grant date for ESPPs.

SC 6, Non-public company stock-based compensation

□ Example SC 6-1 and Example SC 6-2 were added to illustrate the accounting for the grants of

profits interest awards.

SC 7, Stock-based transactions with nonemployees

□ SC 7.2.9 was updated for ASU 2020-06, Debt–Debt with Conversion and Other Options

(Subtopic 470-20) and Derivatives and Hedging–Contracts in Entity’s Own Equity (Subtopic

815-40), which eliminates the requirement to reevaluate convertible securities issued as

compensation awards under other applicable accounting standards, upon the vesting date.

Copyrights

This publication has been prepared for general informational purposes, and does not constitute

professional advice on facts and circumstances specific to any person or entity. You should not act

upon the information contained in this publication without obtaining specific professional advice. No

representation or warranty (express or implied) is given as to the accuracy or completeness of the

information contained in this publication. The information contained in this publication was not

intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions

imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members,

employees, and agents shall not be responsible for any loss sustained by any person or entity that

relies on the information contained in this publication. Certain aspects of this publication may be

superseded as new guidance or interpretations emerge. Financial statement preparers and other users

of this publication are therefore cautioned to stay abreast of and carefully evaluate subsequent

authoritative and interpretative guidance.

About this guide

The FASB material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT

06856, and is reproduced with permission.

Chapter 1: Stock-based compensation overview and scope

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1.1 Stock-based compensation background

The guidance in ASC 718, Compensation—Stock Compensation, applies to various types of equity-

based awards that companies use to compensate their employees (see SC 1.5 regarding terminology

used in this guide). Under ASC 718, companies recognize the fair value of those awards in their

financial statements, generally beginning on the date the awards are granted. This guide covers the

significant accounting aspects of ASC 718, with an emphasis on awards granted by public companies to

their employees. Additional considerations for employee awards granted by nonpublic companies are

discussed in SC 6. The accounting for awards granted to nonemployees is addressed in SC 7.

This guide does not address the income tax, earnings per share, or cash flow implications of stock-

based compensation awards nor other presentation and disclosure matters. Refer to the following PwC

guide sections for guidance on those matters:

□ TX 17 for guidance on income tax accounting consequences

□ FSP 7.5.5.5 for earnings per share implications

□ FSP 6.7.2.7 for cash flow statement considerations

□ FSP 15 for guidance on the presentation and disclosure of stock-based compensation

New guidance

ASU 2018-07

In June 2018, the FASB issued ASU 2018-07, Compensation—Stock Compensation (Topic 718):

Improvements to Nonemployee Share-Based Payment Accounting, to amend the accounting for

share-based payment awards issued to nonemployees. Under the revised guidance, the accounting for

awards issued to nonemployees will be similar to the model for employee awards, except that:

□ the ASU allows an entity to elect on an award-by-award basis to use the contractual term as the

expected term assumption in the option pricing model, and

□ the cost of the grant is recognized in the same period(s) and in the same manner as if the grantor

had paid cash.

The update is effective for public business entities for fiscal years beginning after December 15, 2018,

including interim periods within that fiscal year. For all other entities, the amendments are effective

for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning

after December 15, 2020. Early adoption is permitted, but no earlier than an entity’s adoption of ASC

606.

ASU 2019-08

ASU 2019-08, Compensation—Stock Compensation (Topic 718) and Revenue from Contracts with

Customers (Topic 606), amends ASC 606, Revenue from contracts with customers, to clarify that

consideration payable to a customer also includes equity instruments (for example, shares, share

options, or other equity instruments). SC 7.2.6 and SC 7.2.7 address the accounting for share-based

payments granted to customers upon adoption of ASU 2019-08. Under the clarified guidance,

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consideration paid to a customer in the form of equity instruments that is not in exchange for a

distinct good or service is measured and classified following the guidance in ASC 718 for both equity-

and liability-classified awards. The value determined at the grant date is reflected as a reduction of the

transaction price (and therefore revenue) following the guidance in ASC 606.

ASU 2019-08 is effective for public business entities, and all other entities that have early adopted the

nonemployee guidance in ASU 2018-07, for fiscal years beginning after December 15, 2019, including

interim periods within those fiscal years. For all other entities that have not adopted ASU 2018-07, the

guidance in ASU 2019-08 is effective for fiscal years beginning after December 15, 2019, and for

interim periods within fiscal years beginning after December 15, 2020.

Early adoption, including in interim periods, is permitted in financial statements that have not yet

been issued/made available for issuance, but no earlier than the adoption of the nonemployee

guidance in ASU 2018-07.

1.2 IFRS for stock-based compensation

IFRS 2, Share-based payment, addresses the accounting under international financial reporting

standards for stock-based compensation. Although the guidance in IFRS 2 and ASC 718 is similar,

there are several differences. Refer to PwC’s accounting and financial reporting guide, SD 4, for a

summary of the key differences.

1.3 Awards within the scope of ASC 718

As described in ASC 718-10-15, ASC 718 applies to all equity-based compensation when a company

acquires employee services, or nonemployee goods or services, by:

□ Issuing its stock, stock options, or other equity instruments

□ Incurring liabilities to pay cash, the amounts of which are based, at least in part, on the price of the

company’s stock or other equity instruments

□ Incurring liabilities that may be settled through issuance of the company’s stock or other equity

instruments.

When equity instruments are provided to an individual who is both an employee/nonemployee service

provider and a shareholder, management must analyze the facts and circumstances surrounding the

transaction to determine whether the equity instruments were (a) remuneration for services and

therefore subject to the guidance in ASC 718, or (b) a transaction with a shareholder on terms

commensurate with other non-service-providing shareholders and therefore outside the scope of ASC

718.

ASC 718 addresses all forms of equity-based compensation, including:

□ Stock options

o A contract that gives the holder the right, but not the obligation, either to purchase (to call) or to sell (to put) a certain number of shares at a predetermined price for a specified period of time. Most employee stock options are call options in that they give an employee the right to purchase shares of the company.

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□ Restricted stock and restricted stock units

o Restricted stock is a share of stock granted to an employee for which sale is prohibited for a specified period of time. Most grants of restricted shares to employees are better termed “nonvested shares” because the employees must satisfy certain vesting conditions to earn the rights to the shares, which are, in general, otherwise unrestricted as to transfer.

o Restricted stock units (RSUs) represent a promise to deliver shares to the employee at a future date if certain vesting conditions are met. The difference between RSUs and restricted stock is primarily the timing of the delivery of the underlying shares. A company that grants RSUs does not deliver the shares to the employee until the vesting conditions are met.

□ Stock appreciation rights (SARs)

o A contract that gives the employee the right to receive an amount of stock or cash, the value of which equals the appreciation in a company’s stock price between the award’s grant date and its vesting/exercise date. SARs generally do not involve payment of an exercise price. Regardless of the form of settlement, SARs are subject to the guidance in ASC 718.

□ Employee stock purchase plans (ESPPs)

o Designed to promote employee stock ownership by providing employees with a convenient means (usually through a payroll deduction) to acquire a company’s shares. Refer to SC 5 for information on ESPPs.

□ Employee stock ownership plans (ESOPs)

o A qualified stock bonus plan, or a combination stock bonus and money purchase pension plan, that is designed to invest primarily in employer stock, and that meets the requirements of the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. Refer to SC 11 for information on ESOPs.

□ Long-term incentive plans (LTIPs)

o Generally, LTIPs are cash-settled plans that reward employees based on a company’s performance over a number of years. LTIPs are within the scope of ASC 718 if the amount earned by the employees is based, even in part, on the price of the company’s stock or other equity instruments. For example, an employee may be entitled to a cash payment if the company’s stock price reaches a specified target price or total shareholder return at the end of five years. Cash-settled LTIPs that have payout triggers linked only to employee service (i.e., time-based vesting) or internal performance conditions (e.g., sales or EBITDA targets) are not within the scope of ASC 718 because they are not tied to the price of the company’s stock.

ASC 718 applies to both public and nonpublic companies; although ASC 718 provides nonpublic

companies certain alternatives that are not available to public companies (see SC 6). ASC 718 includes

a definition of a public company.

Excerpt from ASC 718-10-20

Public entity: An entity (a) with equity securities that trade in a public market, which may be either a

stock exchange (domestic or foreign) or an over-the-counter market, including securities quoted only

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locally or regionally, (b) that makes a filing with a regulatory agency in preparation for the sale of any

class of equity securities in a public market, or (c) that is controlled by an entity covered by (a) or (b).

This definition focuses solely on equity securities. Therefore, a company that has publicly traded debt

and no publicly traded equity securities would not be a public entity for purposes of applying ASC 718.

Once a company files for an initial public offering of equity securities (e.g., the date the initial

prospectus is filed with the SEC), it is considered a public company. We believe this would include a

company that has made a confidential submission of financial statements to the SEC under the JOBS

Act in anticipation of a public offering of equity securities. A company whose equity securities are

traded on “Pink Sheets” is also considered a public company. The “Pink Sheet” market is a form of

over-the-counter trading. It is not an exchange, but stock price quotations are available to any investor

who subscribes to the National Quotation Bureau’s Pink Sheet service. Thus, an entity with equity

securities traded in this manner, even if not required to make periodic filings with the SEC, would

meet the ASC 718 definition of a public entity.

The following entities would also be considered a public entity under the definition in ASC 718 because

they are controlled by an entity with equity securities that trade in a public market:

□ A US subsidiary of a parent company whose equity securities are publicly traded in a non-US

jurisdiction.

□ A subsidiary (Company A) that does not have publicly-traded equity securities but is controlled by

a private equity fund (Fund) that in turn is controlled by a public company (Company B) with

publicly traded equity securities. Company B accounts for its investment in Fund at fair value (in

accordance with the Investment Company Act of 1940) rather than consolidating Fund and its

controlled subsidiaries, including Company A. In this scenario, Company A would be considered a

public entity under ASC 718.

□ A limited liability partnership (LLP) that does not have publicly-traded equity securities but is

considered a variable interest entity under ASC 810, Consolidation, and is subject to consolidation

by another entity (Company C) that is the primary beneficiary of the LLP and that has publicly-

traded equity. Due to the LLP being consolidated by Company C under ASC 810, the LLP is

considered to be controlled by a public entity. Therefore, the LLP would meet the definition of a

public entity under ASC 718.

□ A joint venture formed by two companies, Company X and Company Y. Company X has publicly

traded equity securities; Company Y does not. If the joint venture is consolidated by Company X

and accounted for under the equity method by Company Y, the joint venture would be considered

a public entity under ASC 718. However, if the joint venture is consolidated by Company Y and

accounted for under the equity method by Company X, the joint venture is not a public entity

under ASC 718.

The FASB codification contains multiple definitions of “public entity,” “public business entity,”

“publicly traded company,” and “nonpublic entity.” Each of these definitions was developed at a

different time and in the context of specific standards. An entity that fails to meet the definition of a

publicly traded company or public entity under the definitions in other standards may still be a “public

entity” under the ASC 718 definition, and vice versa.

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1.4 Awards by related parties and other economic interest holders

In addition to grants by their employer, employees may earn awards granted by other parties. To

determine which awards are subject to ASC 718, companies should consider awards granted by related

parties or other holders of an economic interest, which includes any person or entity that has a

financial interest in the company (e.g., via equity securities or certain contractual arrangements).

Under ASC 718-10-15-4, if a related party or other economic interest holder of the company grants an

employee of the company an instrument that falls within the scope of ASC 718, that transaction should

be accounted for by the company as stock-based compensation.

For example, if an investor transfers some of its shares to an employee for no consideration, it would

be accounted for as if the investor granted the shares on behalf of the company unless the transaction

is clearly for a purpose other than compensation for services provided by the employee to the

company. The substance of the transaction is that the investor is making a capital contribution to the

company, and the company, in turn, is making a share-based payment to its employee in exchange for

services. Thus, the company would record a capital contribution from the investor and compensation

cost for the value of the shares transferred to the employee.

ASC 718’s definition of a related party is consistent with the definition in ASC 850, Related Party

Disclosures. However, ASC 718’s definition of other economic interest holders includes a broader

array of individuals and entities whose awards to a company’s employees would be subject to ASC 718

because it includes parties that hold any form of financial interest in the company.

1.5 Definition of an employee under ASC 718

Although the accounting for employee and nonemployee awards has been largely aligned under ASC

718 upon adoption of ASU 2018-07, some differences remain. In particular, the attribution of cost and

measurement of instruments awarded to employees differs from instruments awarded to

nonemployees. Therefore, it is important to determine whether the recipient of an award is an

“employee” under ASC 718. Refer to SC 7 for further discussion of nonemployee awards. Throughout

this guide, we generally refer to awards as employee awards; however, unless indicated otherwise,

most of the guidance would be equally applicable to both employee and nonemployee awards given

that ASU 2018-07 eliminated many of the differences.

ASC 718-10-20 defines an employee as someone over whom the grantor of a stock-based

compensation award exercises or has the right to exercise sufficient control to establish an employer-

employee relationship based on common law. All other individuals (aside from the exceptions

described below) who receive stock-based compensation should be considered nonemployees.

1.5.1 Awards to members of a board of directors

A nonemployee who sits on the board of directors and is compensated by the company solely for the

individual’s role as a director will be treated as an employee under ASC 718 if the individual has been:

□ Elected by the company’s shareholders, or

□ Appointed to a board position that will be filled by another person whom the shareholders will

elect when the current term expires.

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Accordingly, an award granted to a nonemployee director should be accounted for as an award granted

to an employee, so long as the award to the nonemployee director is in return for services provided

solely in the person’s capacity as a director. However, an award granted to such a director for non-

board services should be accounted for as a nonemployee transaction.

The exception for nonemployee directors does not extend to independent contractors or advisory

board members (e.g., board members that function in a consulting capacity, provide legal services, or

give scientific advice) because, typically, such individuals are not elected by a company’s shareholders.

Any instruments granted in exchange for nondirector services should be accounted for as a

nonemployee transaction and disclosed as a related-party transaction in the company’s financial

statements, in MD&A, and in the proxy statement.

Subsidiary entities in a consolidated group may have separate boards of directors. In general, only

those outside directors on the board of the parent company are considered employees. However, to the

extent that nonemployee directors on the board of a consolidated subsidiary are elected by

shareholders of the subsidiary that are not controlled, directly or indirectly, by the parent or another

member of the consolidated group, then those directors would also be considered employees under

ASC 718 (e.g., when a subsidiary of a public company is a public company itself). In the separate

financial statements of the subsidiary, members of the subsidiary’s board of directors elected by the

subsidiary’s shareholders, regardless of whether they are independent shareholders or the parent

shareholder, would be considered employees.

1.5.2 Awards to leased and part-time employees

Under the ASC 718 definition of an employee, the primary consideration is whether or not the

individual is considered an employee under common law. A leased individual must also be a common

law employee, but the definition of an employee in ASC 718-10-20 includes additional criteria that

need to be met for a leased individual to be considered an employee, including that the leased

individual be eligible to participate in the lessee’s employee benefit plans, the lessee has the exclusive

right to determine the economic value of the services performed by the lessee, and the lessee has the

right to hire, fire, and control the activities of the individual. If an individual does not meet those

criteria, the individual would be considered a nonemployee.

Part-time employees generally meet ASC 718’s definition of an employee because they are considered

employees under common law.

1.5.3 Awards to employees of a pass-through entity

We believe that the share-based payments awards of a pass-through entity should generally be

considered employee awards if the grantee qualifies as a common law employee. The fact that the

pass-through entity does not classify the grantee as an employee for payroll tax purposes is generally

not relevant given the combined service and ownership relationship of owners in a pass-through entity

(e.g., a partnership or a limited liability company). For guidance on the determination of whether an

award granted by a pass-through entity is akin to equity and therefore a share-based payment award

in the scope of ASC 718, see SC 6.7.

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1.6 Awards to employees of subsidiary or unconsolidated entity

Employees of a subsidiary that is included in the parent company’s consolidated financial statements

are considered employees of the parent company for purposes of applying ASC 718.

Under ASC 718, the employees of an unconsolidated entity’s (e.g., equity method investees, joint

venture) who are granted an instrument in the investor company’s equity are not considered

employees of the investor company. This conclusion would also apply to awards granted by a company

to former employees of the company who are now employed by an unconsolidated joint venture of the

company. See additional discussion in SC 7.2.8 on accounting by an investor for stock-based

compensation granted to employees of an equity method investee.

When an entity grants awards of other entities’ equity to its employees, including, for example, an

equity method investee granting its investor’s equity to the investee’s employees, ASC 718 does not

apply because the awards are not the equity of the granting company. The investee company would

follow the guidance in ASC 815, Derivatives and Hedging (ASC 815-10-55-46 through ASC 815-10-55-

48) for these awards.

Example SC 1-1 illustrates the accounting for awards granted to companies under common control as

part of a consolidated group.

EXAMPLE SC 1-1

Awards granted to employees of companies under common control

Parent is a company with two consolidated subsidiaries, Sub Z and Sub Y. During the year, the

following stock-based compensation is granted:

Scenario 1: Parent grants equity in Parent to Sub Z’s employees

Scenario 2: Sub Z grants equity in Sub Z to Parent’s employees

Scenario 3: Sub Z grants opti0ns to purchase Sub Z’s shares to employees of Sub Y

Scenario 4: Parent grants awards that can be settled in cash (by Parent) to employees of Sub Z

How should the awards be reflected in the financial statements of Parent and its subsidiaries?

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Analysis

Scenario 1: Parent grants equity in Parent to Sub Z’s employees

Parent consolidated financial statements

Sub Z separate financial statements

Awards would be measured at fair value on the grant date and accounted for as awards granted to an employee, as defined by ASC 718.

Awards would be accounted for under ASC 718. Sub Z would recognize compensation cost at grant date fair value. If Sub Z does not provide any consideration to Parent for the awards, the value of the awards granted to Sub Z’s employees would be considered a capital contribution from Parent (i.e., compensation cost with an offsetting entry to capital contribution within equity).

Scenario 2: Sub Z grants equity in Sub Z to Parent’s employees

Sub Z separate financial statements Parent consolidated financial statements

The equity grant would be measured at fair value on the grant date and recognized as a dividend to Parent because as the controlling entity, Parent could require Sub Z to grant the awards to Parent’s employees, even though they are not rendering any services to Sub Z.

The equity grant would be accounted for as employee awards, as defined by ASC 718. Awards of subsidiary equity represent equity (non-controlling interest) in the consolidated entity.

Scenario 3: Sub Z grants opti0ns to purchase Sub Z’s shares to employees of Sub Y


These awards would be accounted for in Parent’s consolidated financial statements as employee awards. This is substantively the same as Scenario 2.

Sub Z separate financial statements Sub Y separate financial statements

The options would generally be measured at fair value on the grant date and recognized as a dividend to Parent because as the controlling entity, Parent could require Sub Z to grant the options to Sub Y’s employees.

Notwithstanding the general model, in certain circumstances it may be appropriate to account for such awards as nonemployee awards and recognize the expense in the grantor’s standalone financial statements provided it is clear that the grantor is receiving services in exchange for the award.

The grant of Sub Z’s options to the employees of Sub Y would generally be considered awards based on the equity of another entity. Under this view, the awards would be accounted for in accordance with ASC 815-10-55-46 through ASC 815-10-55-48 with the change in fair value measured each reporting period and recognized as compensation cost. As the awards are provided to Sub Y by Parent, the change in fair value would be considered a capital contribution and recognized as an increase or decrease in Parent’s equity in Sub Y’s standalone financial statements.

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Scenario 4: Parent grants awards that can be settled in cash (by Parent) to employees of Sub Z.


Sub Z separate financial statements

Since the awards allow for cash settlement at the employee's election, they would be liability-classified in Parent’s consolidated financial statements. Accordingly, the awards would be remeasured each reporting period by Parent until final settlement.

The awards would be accounted for as employee awards under ASC 718. The impact of remeasuring the awards each reporting period should be reflected (“pushed down”) in Sub Z’s standalone financial statements, generally as a capital contribution from Parent (i.e., compensation cost with an offsetting entry to capital contribution within equity). Sub Z would not record a liability as it is not legally obligated to make the payment.

1.7 Awards based on a tracking stock

A tracking stock is a security issued by a parent company to track the results of one (or more) of its

subsidiaries or lines of business. Tracking stock is considered for legal and accounting purposes to be

equity of the parent company, and not equity of the unit or subsidiary to which the stock tracks. The

holders of tracking stock are considered to hold equity of the parent and not the specific entity

represented by the tracking stock. As such, awards based on a tracking stock should generally be

accounted for as equity awards of the parent if the tracking stock is deemed to be substantive. We

believe that the following factors would be considered to determine whether a tracking stock is

substantive:

□ Reasons for the issuance

□ Whether the shares have been issued to third parties

□ Whether the voting rights of the holders of the tracking stock are similar to the rights of the

holders of the parent company stock

If tracking stock is not deemed to be substantive (e.g., issued only to management for purposes of

paying out cash based on certain divisions’ results), it would not be considered equity for share-based

payment purposes and the award should be accounted for as either a cash-based award or as a

formula-based award.

1.8 Changes in employment status and share-based awards

The status of a recipient of an award may change to or from an employee while he or she continues to

provide service. For example, an employee may terminate employment with a company and continue

to provide service as a nonemployee consultant. As discussed above, there are differences in the

accounting for awards granted to employees as compared to nonemployees.

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1.8.1 Status change—awards with ongoing service after ASU 2018-07

ASC 718 does not provide specific guidance on accounting for a change in employment status when the

recipient continues to provide substantive services. When the recipient of an award changes

employment status and continues to provide service and vest in an award, the company should assess

whether the award was modified in connection with the change in status. The company should also

make an assessment as to whether the future services to be provided by the individual are substantive.

If the award was modified to allow the recipient to continue vesting in the award after the change in

status and the future service was deemed substantive, the modification should be treated as a

cancellation of the old award and issuance of a new award. In this scenario, the compensation cost

previously recognized related to the old award would be reversed when it is no longer probable of

vesting. The full amount of compensation cost related to the new (modified) award would be measured

as a nonemployee award under ASC 718 (see SC 7.2.3) and recognized prospectively over the new

vesting period. This is a Type III modification under ASC 718 (as discussed in SC 4.3.1) because at the

modification date, the service condition of the original award is not expected to be satisfied.

After adoption of ASU 2018-07, if the award was not modified in connection with the change in status

(i.e., the original terms of the award provided for continued vesting for service provided as a

nonemployee consultant, such that the individual was contractually entitled to retain the award), but

future substantive service is still necessary to earn the award, then the original grant date fair value of

the award would continue to be recognized. Attribution of the remaining cost would follow the

nonemployee guidance prospectively from the date of the change in status (see SC 7.2.5).

1.8.1A Status change—awards with ongoing service pre-ASU 2018-07

ASC 718 does not provide specific guidance on accounting for a change in employment status when the

recipient continues to provide substantive services. When the recipient of an award changes

employment status and continues to provide service and vest in an award, the company should assess

whether the award was modified in connection with the change in status. The company should also

make an assessment as to whether the future services to be provided by the individual are substantive.

If the award was modified to allow the recipient to continue vesting in the award after the change in

status and the future service was deemed substantive, the modification should be treated as a

cancellation of the old award and issuance of a new award. In this scenario, the compensation cost

previously recognized related to the old award would be reversed when it is no longer probable of

vesting. The full amount of compensation cost related to the new (modified) award would be measured

as a nonemployee award under ASC 505-50 (see SC 7.2A) and recognized prospectively over the new

vesting period. This is a Type III modification under ASC 718 (as discussed in SC 4.3.1) because at the

modification date, the service condition of the original award is not expected to be satisfied.

Prior to adoption of ASU 2018-07, if the award was not modified in connection with the change in

status (i.e., the original terms of the award provided for continued vesting for service provided as a

nonemployee consultant, such that the individual was contractually entitled to retain the award), but

future substantive service is still necessary to earn the award, then compensation cost should be

measured as if the outstanding award was newly granted at the date of the change in status as a

nonemployee award. For example, if an employee becomes a nonemployee consultant and continues

to vest in an equity-classified award (under the original terms of the award), the unvested portion of

the award should be measured under the nonemployee guidance on the date of the change.

Compensation cost for the remaining proportion of the vesting period should be measured and

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recognized prospectively from the date of the change in status over the remaining vesting period,

following the guidance in ASC 505-50 (see SC 7.2A). No adjustment should be made to any

compensation cost recognized prior to the change in status unless the award is forfeited prior to

vesting. In essence, the total compensation cost recognized for the award is measured partially under

ASC 718 (i.e. the proportion of the vesting period prior to the date of the change in status) and partially

under ASC 505-50 (i.e. the proportion of the vesting period subsequent to the date of the change in

status).

1.8.2 Changes in status and awards with no future services

As described in SC 1.8.1, when an employee becomes a nonemployee and is allowed to continue to vest

in existing awards, an assessment should be made as to whether future services to be provided by the

individual are substantive.

If the services are not substantive, the compensation cost would be accounted for as a severance

arrangement with no future service requirement (i.e., recognized immediately). All of the relevant

facts and circumstances should be considered to determine whether an individual is providing

substantive services, including whether the individual’s compensation is reasonable in relation to the

services to be provided and whether there is a clear understanding of the individual’s role and

responsibilities, supervision of the individual’s performance, and monitoring of hours worked.

Example SC 1-2 illustrates the accounting for an award that is modified to allow continued vesting

upon a separation when no substantive future service is required.

EXAMPLE SC 1-2

Change in status – no substantive future service

On December 31, 20X6, SC Corporation enters into a separation agreement and consulting

arrangement with an executive. In accordance with the agreements:

□ The executive will be "on call" for one hour per month through June 30, 20X8 as a consultant to

the Company, and

□ The executive's outstanding unvested options on the date of the agreement are modified so that

they will continue to vest through June 30, 20X8, at which time the executive will have 90 days to

exercise the options.

How should the Company account for the stock options?

Analysis

The accounting should be based on the substance of the separation agreement and not the form. The

substance of the agreement is that the executive does not have to provide future services to SC

Corporation (except for a non-substantive amount of “on call” time) in order to continue vesting in the

unvested options. The unvested options should therefore be viewed as immediately vested with a

delayed exercise date. The modification is a Type III modification (as discussed in SC 4.3.1) and

incremental compensation cost should be recognized immediately.

Chapter 2: Measurement date, vesting conditions, and expense attribution

Measurement date, vesting conditions, and expense attribution

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2.1 Measurement date, vesting, and expense attribution overview

This chapter discusses the measurement and recognition of compensation cost for employee stock-

based awards. Employee awards are measured at fair value on the grant date and the resulting

compensation cost is recognized over the requisite service period. Awards typically include vesting

conditions, which could impact the amount of compensation cost recognized or the timing of

recognition.

This chapter generally addresses the accounting for equity-classified awards; however, many of the

concepts discussed also apply to liability-classified awards (e.g., the impact of vesting conditions).

Refer to SC 3 for further discussion of liability-classified awards.

2.2 Stock-based compensation measurement basis and objective

ASC 718 principally requires the use of the “fair-value-based method” for measuring the value of stock-

based compensation. Employee stock options generally are not tradeable in the financial markets and

also generally have features and restrictions that differ from those of publicly traded options. Those

features and restrictions affect the fair value of employee stock options (e.g., nontransferability and

nonhedgeability). Therefore, ASC 718 requires that, in applying the “fair-value-based method,”

companies use an option-pricing model adjusted to accommodate the unique characteristics of

employee stock options.

For the sake of convenience, however, ASC 718 generally refers to the required measure of stock-based

compensation as fair value; that term also distinguishes the measure from other measures, such as

intrinsic value and calculated value. In ASC 718 and in this guide, references to fair value mean the

“fair-value-based measure” that is determined in accordance with the requirements of ASC 718, rather

than the term “fair value” as used in ASC 820, Fair Value Measurement.

ASC 718’s measurement objective is to determine the fair value of stock-based compensation at the

grant date assuming that employees fulfill the award’s vesting conditions and will retain the award.

The fair value of an award is the cost to the company of granting the award and should reflect the

estimated value of the instruments that the company would be obligated to provide to an employee

when the employee has satisfied the service conditions. For most awards, the cost will be measured

once at the grant date fair value and will not be adjusted for subsequent changes in fair value.

When determining fair value (in accordance with ASC 718-10-55-10 through ASC 718-10-55-12),

companies should take the following steps:

□ Step 1: Consider observable market prices of identical instruments (if available), taking into

consideration the terms of the instruments and the conditions upon which they were granted.

□ Step 2: Consider observable market prices of similar instruments (if available), taking into

consideration the terms of the instruments and the conditions upon which they were granted.

Management should assess whether an instrument is similar to marketplace instruments, basing

its conclusion on an analysis of the instrument’s terms, along with an evaluation of other relevant

facts and circumstances.


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□ Step 3: If identical or similar instruments are not available in the marketplace, use a valuation

technique, such as an option-pricing model (e.g., Black-Scholes, lattice/binomial). The valuation

technique should be:

o Consistent with ASC 718’s fair value measurement objective.

o Based on established principles of economic theory.

o Generally accepted by experts (i.e., broadly acknowledged and supported by valuation experts in both academia and practice).

o Capable of reflecting any and all substantive characteristics of the award (except for characteristics that are explicitly excluded by ASC 718, such as reload features, as discussed in SC 2.4).

2.2.1 Use of market instruments to value employee stock options

Although ASC 718 suggests that employee stock options may be valued by reference to similar

instruments in the marketplace, this approach is uncommon in practice. Most employee awards have

unique features that are difficult, if not impossible, to replicate in a third-party arrangement. Some

companies have tried to create a marketplace in which they can trade instruments that are similar to

employee stock options so that they can use observable market prices instead of an option-pricing

model to estimate the fair value of their employee stock options.

In September 2005, the SEC’s Office of Economic Analysis (OEA) issued a memorandum that

discusses potential instrument designs that may be used in developing a market instrument to

estimate the fair value of employee stock options. The OEA memorandum identifies three key

elements of a market-instrument approach: (1) instrument design, (2) a credible information plan that

enables prospective buyers and sellers to price the instrument, and (3) a market pricing mechanism

through which the instrument can be traded to establish a price. The OEA memorandum does not

discuss information plans and market pricing mechanisms in detail, but discusses two possible

approaches to instrument design, referred to as the “tracking approach” and the “terms and conditions

approach.” In general, OEA concludes that an instrument designed under the tracking approach could

produce a fair value estimate that reflects the cost to the company of granting the stock option.

However, it concludes that an instrument designed under the terms and conditions approach will

likely not produce a reasonable estimate of the fair value of employee stock options consistent with the

measurement objective of ASC 718.

There are significant issues that a company needs to address in order to successfully implement a

market instrument approach, including the development of an information plan that is easily

accessible to all market participants and enables prospective buyers and sellers to price the

instrument, as well as a market pricing mechanism that has adequate participation by willing buyers

and sellers. Based on the views expressed by the SEC staff, a market instrument approach that results

in a fair value that is significantly different from the fair value obtained from an option pricing model

could face skepticism from the SEC staff, especially in the early stages of the development of market

instruments.


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2.2.2 Option-pricing models

The option-pricing model used to measure fair value of an award and the specific assumptions input

into the model have a direct effect on the amount of compensation cost recognized for the award. SC 8

provides an overview of how to select an option-pricing model and the supporting financial theory,

discusses the required assumptions, and explains the differences between the various types of models.

2.2.3 Inability to estimate fair value of a stock-based award

A company should be able to reasonably estimate the fair value of stock-based compensation awards

on the grant date. When, in rare circumstances, the complexity of an award’s terms makes it

impossible to reasonably estimate the award’s fair value on the grant date, a company will measure

compensation cost by using the award’s intrinsic value each reporting period through the date of

exercise or other settlement. Even if the company were to later conclude that it can reasonably

estimate the fair value of the award (e.g., if a new valuation technique was developed), the company

would continue using the intrinsic-value method until the award is settled.

Remeasuring awards at their intrinsic value each reporting period may result in significant

fluctuations to compensation cost, especially if the underlying stock price were to increase.

2.2.4 Restricted stock award

The term “restricted stock” is commonly used to describe two different arrangements: (1) shares that

are legally restricted as to transfer and may be held by any shareholder, including shares issued to

employees and (2) “nonvested shares” that are share awards issued to employees and subject to

vesting conditions. ASC 718 distinguishes between “nonvested shares” and “restricted shares.” This

guide generally refers to nonvested shares as restricted stock.

2.2.4.1 Nonvested share award

The fair value of restricted stock and restricted stock units (RSUs) is generally measured as the grant-

date price of the company’s shares. If employees are not entitled to dividends declared on the

underlying shares while the restricted stock or RSU is unvested, the grant-date fair value of the award

is measured by reducing the grant-date price of the company’s shares by the present value of the

dividends expected to be paid on the underlying shares during the requisite service period, discounted

at the appropriate risk-free interest rate. Conversely, if dividends are paid during the vesting period or

accumulated and paid to the employee upon vesting, the grant-date fair value of the award should not

be reduced.

See SC 2.9 for guidance on accounting for dividends received by holders of restricted stock or RSUs.

2.2.4.2 Restricted share award

As the term is used in ASC 718, “restricted shares,” as distinguished from nonvested shares discussed

in SC 2.2.4.1, refer to shares that are owned by the employee that contain restrictions on sale or

transfer, such as a share whose sale is contractually or governmentally prohibited for a specified

period of time after the employee has a vested right to it. These types of restrictions are often referred

to as “post-vesting restrictions.” A restricted share is measured at its fair value, which is the same

amount at which a similarly restricted share would be issued to third parties. In other words, the effect

of the post-vesting restriction is considered in determining the fair value of the award; however, ASC


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718-10-55-5 notes that if shares are traded in an active market, post-vesting restrictions may have

little, if any, effect on the value of the shares.

The definition of a restriction in ASC 718 is a prohibition on resale, rather than a limitation on resale.

For example, securities laws may prohibit the sale of a security to other than qualified institutional

buyers or in other exempt transactions (e.g., a Rule 144A exempt offering). Such a limitation does not

represent a prohibition as contemplated by the definition of a restriction in ASC 718. Therefore, a

limitation such that the shares can be transferred only to a limited population of investors should not

be considered in the estimate of fair value.

Example SC 2-1 illustrates the definition of restricted shares.

EXAMPLE SC 2-1

Share award with sale restrictions

SC Corporation grants a vested share award that restricts an employee from selling the shares until the

employee terminates employment.

Are the shares considered “restricted shares”?

Analysis

No. ASC 718-10-20 defines a restricted share as “a share for which sale is contractually or

governmentally prohibited for a specified period of time.” If the restrictions lapse on a voluntary

termination then the shares are not subject to a contractual or governmental prohibition on sale, as

the employee could leave employment and sell the shares. SC Corporation should determine fair value

of the award based on the price of SC Corporation’s shares on the grant date and recognize

compensation cost immediately, as the shares are fully vested.

2.3 Recourse and nonrecourse notes to purchase stock

Entities may allow employees to purchase stock or exercise stock options in exchange for a note

payable to the company. The accounting for these arrangements depends on whether the note is a

recourse or nonrecourse loan.

2.3.1 Recourse notes to purchase stock

A recourse loan is an enforceable obligation under which a default by the borrower (employee in this

context) entitles the lender (employer in this context) to pursue recovery from any and all of the assets

of the employee. A recourse loan may or may not be collateralized. A collateralized loan simply means

that specified assets of the borrower have been identified to provide specific security to the lender

(e.g., the shares of stock that the employee purchased with the loan) or other investment assets of the

employee have been placed in an escrow account. A collateralized loan may or may not be a full

recourse obligation. An uncollateralized loan may still legally provide for full recourse against the

assets of the employee upon default. Generally, an exercise of a stock option or purchase of stock with

a recourse note from a company to an employee is considered to be a substantive exercise or purchase.

However, a company will need to determine whether a loan that is in the form of a recourse note is in

substance that of a nonrecourse note.


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In general, we believe the legal form of a recourse note should be respected (i.e., the stock option is

considered to be exercised) unless any one of the following conditions exist:

□ Although the employer has legal recourse to the employee’s other assets, it does not intend to seek

repayment beyond the shares issued,

□ The employer has a history of not demanding repayment of loan amounts in excess of the fair

value of the shares,

□ The employee does not have sufficient assets or other means (beyond the shares) to justify the

recourse nature of the loan, or

□ The employer has accepted a recourse note upon exercise and subsequently converted the recourse

note to a nonrecourse note in the past.

If any of the above conditions exist, the recourse note should generally be considered to be

nonrecourse. In addition to the criteria above, all other relevant facts and circumstances should be

evaluated when determining whether the note should be considered to be nonrecourse in nature.

If the loan is recourse in nature, the loan generally should be reported as a deduction from

shareholders’ equity; the shares relating to the loan should be included in the earnings and dividends

per share computations, dividends paid on the shares relating to the loan should be charged to

retained earnings, and interest on the loan should be credited to income as it accrues.

If the loan is considered nonrecourse in nature, the substance of the arrangement is that the stock

option remains unexercised. Nonrecourse notes are discussed in more detail in SC 2.3.2.

2.3.1.1 Non-market interest rate on recourse note to buy stock

A company may permit an employee to purchase stock with a recourse note that is noninterest bearing

or has a below-market interest rate. The issuance of such a note results in a purchase price that is

below fair value. Therefore, compensation cost will be recognized by the company for the difference

between the fair value of the stock and the estimated present value of the note. The determination of

the note’s present value should be based on a market rate of interest that would be required for the

employee.

2.3.1.2 Forgiveness of a recourse note to purchase stock

A company may subsequently decide to forgive a note and accrued interest that was initially presumed

to be recourse. On the date of forgiveness, the company should record compensation cost for the

amount of the note and accrued interest forgiven, offset by any recoveries. This event may also require

the company to re-evaluate whether there was an intention to forgive the note when it was originally

issued and whether other outstanding notes are, in substance, nonrecourse notes.

2.3.1.3 Extension of the term of recourse notes to purchase stock

A company may extend the payment terms on the principal of a recourse note. Such an extension of

the terms of a recourse note does not necessarily result in the conversion of the recourse note to a

nonrecourse note. However, the company would need to consider the reason for the term extension

and whether the note is still, in substance, with recourse. Accordingly, on the date of the extension, the

company should reconsider if any one of the four conditions found in SC 2.3.1 are met. If any of the

conditions are present at the date of the extension, the recourse note should generally be considered to


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have been converted to a nonrecourse note (see SC 2.3.1.4 for more guidance). Further, a company

should consider whether additional compensation cost should be recorded if the extension of the

payment terms included the conveyance of additional value to the employee. This may occur, for

example, if the new term includes an interest rate that is below-market for the employee at the time of

the extension.

2.3.1.4 Conversion of a recourse note to a nonrecourse note

A company may legally change a recourse note to a nonrecourse note or determine that a recourse note

has substantively changed to a nonrecourse note. Such conversions should be accounted for as the

repurchase of the shares previously received by the employee upon exercise of the stock option or

stock purchase and the grant of a new award in exchange for a nonrecourse note. The repurchase

should be accounted for as a treasury stock transaction and the company should recognize

compensation cost for any excess of the repurchase amount over the fair value of the shares. The

repurchase amount is equal to the sum of (a) the then current unpaid principal balance of the recourse

note, (b) the unpaid accrued interest and (c) the fair value of the new option (i.e., the nonrecourse note

to purchase stock). Any compensation cost to be recognized should be recognized over the requisite

service period of the new award, if any.

2.3.2 Nonrecourse note to purchase stock

A nonrecourse note issued by an employee to a company to satisfy the exercise price of an option or to

purchase stock is neither collateralized by nor provides the company recourse to the assets of the

employee, other than the stock issued. A nonrecourse note received by a company as consideration for

the issuance of stock is considered a stock option for accounting purposes—i.e., it remains subject to

settlement/exercise—as the substance is similar to a stock option. Similarly, exercising an option with

a nonrecourse note essentially means that the option remains unexercised. In either case, the

employee is effectively deferring the decision to “exercise” the “stock option” until they repay the loan.

If the value of the shares declines below the loan amount, the “stock option” is underwater and the

employee would generally not be expected to repay the loan since there is no recourse to the

employee’s assets other than the shares.

In these arrangements, the exercise price of the “stock option” is the principal and interest due on the

note. The fair value of the “stock option” is recognized in a company’s financial statements over the

requisite service period through a charge to compensation cost and a corresponding credit to APIC or

to a liability, depending on the classification of the award. The requisite service period is the period the

employee is required to perform service in order to retain the shares, which may differ from the term

of the note. For example, it is common for a company to have the right to repurchase the shares at the

loan amount if an employee leaves within a specified period of time, which establishes a service period.

The maturity date of the note reflects the contractual term of the option for purposes of valuing the

award. If the employee is not required to provide future service (i.e., the employee can repay the note

at any time and keep the shares), the company should recognize the fair value of the award as

compensation cost on the grant date, rather than over the term of the note.

When a nonrecourse note is used to fund the exercise of a stock option, the stock option is not

considered “exercised” for accounting purposes until the employee repays the loan. Prior to repayment

of a nonrecourse loan, the outstanding shares received in exchange for the loan are excluded from the

denominator of basic earnings per share. Additionally, the nonrecourse loan itself is not recorded on

the company’s balance sheet since the arrangement is, in substance, a stock option.


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2.3.2.1 Nonrecourse note—interest linked to a third-party index

A company may permit an employee to exercise a stock option or purchase stock with a nonrecourse

note that has a variable rate of interest that is linked to a third party index over the term of the note

(e.g., a nonrecourse note that has an interest rate tied to LIBOR). Given the nonrecourse nature of the

loan, the company should account for the transaction as a stock option and the exercise price of the

“option” should include the principal and interest due on the note. Because the exercise price is linked

to a third-party index, the award is indexed to a factor that is not a market, performance or service

condition and the award would be classified as a liability (ASC 718-10-25-13).

2.3.2.2 Nonrecourse note to purchase stock with recourse interest

Typically, the interest on a nonrecourse note executed for the purchase of stock or exercise of a stock

option is also nonrecourse. However, in certain circumstances, a company may receive a nonrecourse

note that includes recourse interest. In such a case, the company should account for the transaction as

a stock option. However, the company should not include the interest as part of the option’s exercise

price as it is subject to full recourse. As a result, the price of the option equals the principal amount of

the note.

2.3.2.3 Dividends paid on nonrecourse notes to purchase stock

A company may pay dividends to an employee who purchased stock or exercised a stock option with a

nonrecourse note. Because a nonrecourse note received as consideration for the issuance of stock is

considered an outstanding stock option until the note’s principal and interest are paid in full, any

dividends paid by the company during the period the note is outstanding would be charged to retained

earnings for the equity-classified awards that are expected to vest. For the equity-classified awards

that are not expected to vest or do not ultimately vest, dividends paid would be recognized as an

additional compensation cost.

See SC 2.9 for more guidance on accounting for dividends received by holders of options or shares

issued.

2.3.2.4 Forgiveness of a nonrecourse note to purchase stock

A company may accept a nonrecourse note for the purchase of stock or the exercise of stock options

but subsequently decide to forgive the nonrecourse note and accrued interest and not require the

employee to return the shares. As the note was initially nonrecourse, the issuance of stock was

considered a stock option for accounting purposes. Therefore, the forgiveness of the note is in effect a

repricing of the options’ exercise price to zero. As a result, on the forgiveness date, the company would

apply modification accounting under ASC 718-20-35-3 through ASC 718-20-35-4 and calculate any

incremental compensation cost to be recognized.

If a company forgives a nonrecourse note and accrued interest and requires the employee to return the

shares, then the company should treat the forgiveness as a cancellation without the concurrent grant

of a replacement award (i.e., a settlement with no consideration). Refer to SC 4.9 for the accounting

related to cancellations without the concurrent grant of a replacement award.

2.3.2.5 Cash loans through a nonrecourse note secured by shares

An employer may provide an employee with a nonrecourse cash loan collateralized by the employee’s

shares in the employer. In this case, there is both an accounting and economic event that need to be

reflected in the financial statements. As described in SC 2.3.2, the cash received by the employee in

exchange for the nonrecourse loan is treated as an option for accounting purposes. The employee no


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longer has downside risk on the shares below the loan balance and must pay off the loan–akin to

exercising the option–to “reobtain” full rights to the shares. Thus, the employee has effectively

received cash and an option in exchange for giving up the full rights to the shares that the employee

previously owned “free and clear.”

While this transaction is not explicitly addressed in ASC 718, we believe it is economically similar to

the guidance for converting a full recourse note to a nonrecourse note. As described in SC 2.3.1.4, such

conversions should be accounted for as the repurchase of the shares previously held by the employee

and the grant of a new award in exchange for a nonrecourse note. The repurchase should be accounted

for as a treasury stock transaction, and the company should recognize compensation cost for any

excess of the repurchase amount over the fair value of the shares.

In the case of issuing cash in return for a nonrecourse loan secured by shares, the consideration issued

to the employee is the amount of the cash loan plus the fair value of the option represented by the

nonrecourse loan.

Example SC 2-2 illustrates the accounting for cash loaned to an employee in return for a nonrecourse

note.

EXAMPLE SC 2-2

Cash loaned to an employee in exchange for a nonrecourse note secured by shares

SC Corporation, a nonpublic company, loans its CEO $1,000,000 for personal use. The loan has a

fixed annual interest rate, and principal and accrued interest are due in full in five years. The loan is

secured only by 100,000 common shares of SC Corporation that the CEO acquired through a stock

option exercise a year earlier. The loan provides no recourse to any other assets held by the CEO. The

current fair value of the pledged shares is $1,500,000. During the term of the loan, the CEO is not

permitted to sell or otherwise transfer the pledged shares.

How should SC Corporation account for the loan?

Analysis

Although the loan proceeds are not being used to exercise stock options or purchase stock, the

nonrecourse nature of the loan secured by the shares pledged as collateral essentially provides the

CEO with rights similar to that of a stock option (as described in ASC 718-10-25-3). Similar to an

option, the CEO could choose not to repay the loan and surrender the pledged shares or pay the loan

in full and retain the rights to the shares. In other words, the CEO is protected from downside risk but

retains unlimited upside potential (whereas prior to the transaction, the CEO was subject to both the

upside and downside risk of share ownership). SC Corporation has effectively repurchased the pledged

shares and issued the CEO an option to buy back the shares with a strike price equal to the loan

principal plus accrued interest.

The repurchase should be accounted for as a treasury stock transaction, and SC Corporation should

recognize compensation cost for any excess of the repurchase amount over the fair value of the shares

pledged. The repurchase amount is the consideration exchanged for the pledged shares, which in this

case is equal to the sum of the cash loaned and the fair value of the in-substance option to buy back the

pledged shares. For purposes of this example, assume the company estimated the fair value of the

option to be $800,000. The option is the right to buy back the pledged shares at an exercise price

http://www.pwccomperio.com/contents/english/external/us/gaap/718/718-10-25.htm#p25-3


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equal to the loan principal plus accrued interest. The expected term of the option would equal the term

of the loan (considering prepayment terms, if applicable). SC Corporation would calculate total

compensation cost as follows:

Loan proceeds $1,000,000

Fair value of option $800,000

Total repurchase price $1,800,000

Fair value of pledged stock ($1,500,000)

Total compensation cost to be recognized $300,000

SC Corporation would recognize the compensation expense over the requisite service period, if any,

which may differ from the term of the loan. Depending on the circumstances, there may not be a

service period associated with the option, in which case compensation cost would be recognized

immediately.

SC Corporation would record the following journal entries:

Dr. Treasury stock $1,500,000

Cr. Cash $1,000,000

Cr. Additional paid-in capital $ 500,000

To recorded issuance of the loan

Dr. Compensation expense $300,000

Cr. Additional paid-in capital $300,000

To record compensation expense over the requisite service period associated with the arrangement,

if any

2.3.3 Part recourse and part nonrecourse note to purchase stock

Within superseded stock compensation literature (Issue 34 of EITF Issue 00-23), there was a

discussion on loans that were part recourse and part nonrecourse. Such notes are occasionally used to

obtain favorable tax consequences to the employee. Such notes should be accounted for as

nonrecourse in their entirety if the note is not aligned with a corresponding percentage of the

underlying shares (i.e., the note is not related to a pro-rata portion of the shares).

2.4 Reloads and clawback features of stock compensation awards

A reload feature and reload option is defined in the ASC Master Glossary and generally provides for

the automatic grant of additional options whenever an employee exercises previously granted options

using shares, instead of cash for the exercise price. A clawback typically requires that an employee

return the award (or underlying assets) if certain conditions are met (ASC 718-10-55-8). Companies


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should not consider those features when determining an award’s grant-date fair value. As required by

ASC 718-10-30-23 through ASC 718-10-30-24 and ASC 718-20-35-2, those features would only be

considered when relevant transactions occur pursuant to those features. As a result, a subsequent

option grant under a reload feature would be considered a new and separate award when granted. See

also SC 10.2.4 for further discussion on awards with clawback features.

2.5 Vesting conditions for stock-based compensation awards

In order to motivate and retain employees, companies typically require that employees fulfill certain

conditions to earn and retain stock-based compensation awards. These are commonly called vesting

conditions. An award is legally vested when an employee’s right to receive or retain the award is no

longer contingent on satisfying the vesting condition.

Exercisability refers to the date when an option may be exercised by the employee. In most cases, the

vesting date and the exercisability date are the same. However, option plans sometimes specify

conditions in which vesting occurs before the employee is allowed to exercise the option. In that case,

an employee who is vested will be able to retain the option after termination of employment even

though it cannot be exercised until some future date. Compensation cost is generally recognized from

the grant date through the vesting date, but exercisability provisions may affect the expected term

assumption and therefore, fair value. See SC 9.3.

While most stock-based compensation awards contain time-based vesting conditions, the terms of

some awards contain provisions specifying that vesting, exercisability, or some other factor (e.g., the

exercise price) depends on the achievement of an established target, as described in SC 2.5.2 and SC

2.5.3.

2.5.1 Definitions of vesting conditions for stock-based awards

ASC 718 defines three types of vesting conditions:

□ Market condition

□ Performance condition

□ Service condition

The accounting for an award will depend on which conditions are included in the award’s terms. If the

award is indexed to a factor other than a market, performance, or service condition, the award should

be classified as a liability. In some circumstances, awards could have multiple conditions (see SC

2.5.4). Figure SC 2-1 defines and gives examples of each condition.


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Figure SC 2-1 Types of vesting/exercisability conditions

Market condition Performance condition Service condition

Definition [Excerpted from ASC 718-10-20, as updated by ASU 2018-07]

A condition affecting the exercise price, exercisability, or other pertinent factors used in determining the fair value of an award under a share-based payment arrangement that relates to the achievement of (a) a specified price of the issuer’s shares or a specified amount of intrinsic value indexed solely to the issuer’s shares or (b) a specified price of the issuer’s shares in terms of a similar (or index of similar) equity security (securities).

A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both (a) rendering service or delivering goods for a specified (either explicitly or implicitly) period of time and (b) achieving a specified performance target that is defined solely by reference to the grantor’s own operations (or activities) or by reference to the grantee’s performance related to the grantor’s own operations (or activities). A performance target also may be defined by reference to the same performance measure of another entity or group of entities.

A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that depends solely on an employee rendering service to the employer for the requisite service period or a nonemployee delivering goods or rendering services to the grantor over a vesting period. A condition that results in the acceleration of vesting in the event of a grantee’s death, disability, or termination without cause is a service condition.

Examples A stock option that becomes exercisable when the underlying stock price exceeds the exercise price by a specified amount (e.g., $10 above the exercise price).

Award that vests if a sales target of $3 million is achieved.

Award that vests as a result of achievement of a defined EPS target.

Award that vests if the employee provides three years of service.

Award for which vesting depends on the movement of the underlying stock or total shareholder return (TSR) relative to a market index of peer companies.

Award that vests based upon a specified rate of return to a controlling shareholder (e.g., internal rate of return, multiple of invested capital).

An award that vests when the company achieves a specified market capitalization.

Award that vests as a result of an initial public offering, some other financing event, a change in control, or the company’s achieving a specified growth rate in its return on assets.

Award that vests upon an employee’s death, disability, or termination without cause.


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2.5.2 Market conditions of stock-based compensation awards

An award with a market condition is accounted for and measured differently from an award that has a

performance or service condition. The effect of a market condition is reflected in the award’s fair value

on the grant date (e.g., using an advanced option-pricing model, such as a lattice model). That fair

value will be lower than the fair value of an identical award that has only a service or performance

condition because the effect of the market condition results in a discount relative to the fair value of an

award without a market condition. All compensation cost for an award that has a market condition

should be recognized if the requisite service period is fulfilled, even if the market condition is never

satisfied (i.e., even if the award never vests). This is because the likelihood of achieving the market

condition is incorporated into the fair value of the award.

2.5.3 Performance and service conditions that affect vesting

For an award with a performance and/or service condition that affects vesting, the performance

and/or service condition is not considered in determining the award’s fair value on the grant date. For

companies that elect to estimate forfeitures (see SC 2.7.1), service conditions should be considered

when a company is estimating the quantity of awards that will vest (i.e., the pre-vesting forfeiture

assumption). Compensation cost will reflect the number of awards that are expected to vest and will be

adjusted to reflect those awards that do ultimately vest.

A company should recognize compensation cost for awards with performance conditions if and when

the company concludes that it is probable that the performance condition will be achieved. ASC 718’s

use of the term probable is consistent with that term’s use in ASC 450, Contingencies, which refers to

an event that is likely to occur (ASC Master Glossary). If there are multiple potential outcomes of the

performance conditions that can affect the quantity or terms (e.g., exercise price or contractual term)

of an award, the company should calculate a grant-date fair value for each potential outcome, and

recognize compensation cost based on the value associated with the probable outcome, consistent with

ASC 718-10-30-15. A company should reassess the probability of vesting at each reporting period for

awards with performance conditions and adjust compensation cost based on its probability

assessment. A company should recognize a cumulative catch up adjustment for such changes in its

probability assessment in subsequent reporting periods, using the grant date fair value of the award

whose terms reflect the updated probable performance condition, consistent with the guidance in ASC

718-10-55-78 and ASC 718-10-55-79.

In certain situations, a company may not be able to determine that it is probable that a performance

condition will be satisfied until the event occurs. For example, a company typically cannot conclude it

is probable that a liquidity event, such as a change in control of the company, will occur until the date

of consummation of the liquidity event because such an event is outside the company’s control.

Accounting for the related compensation expense at the time the event occurs is also consistent with

the guidance in ASC 805-20-55-50 through ASC 805-20-55-51, which states that termination benefits

triggered by the consummation of a business combination should be recognized when the business

combination is consummated.

A distinction, however, should be made between the sale of an entire entity (i.e., a change in control)

and the sale of a portion of an entity that is a business (e.g., a business unit). When considering

probability for the sale of a business unit, the threshold for the sale is analyzed differently than for the

sale of the entity. If the sale of a business unit were to meet the “held for sale” criteria of ASC 360,

Property, Plant and Equipment, the sale may be considered probable because meeting the held-for-

sale criteria creates the presumption that management controls the sale.


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Example SC 2-3 illustrates the accounting for awards with performance conditions.

EXAMPLE SC 2-3

Award with performance conditions

On January 1, 20X1, SC Corporation grants stock options to employees that vest in three tranches

based on achieving a defined EBITDA target in each of the next three years (20X1, 20X2, and 20X3).

The employees must also provide service for the entire three years to vest in the options. For example,

the first tranche of options vests based on achieving a defined EBITDA target in 20X1 and the

employees providing service through the end of 20X3. No employees are expected to terminate

employment during the three-year period and SC Corporation estimates forfeitures.

As of the grant date, SC Corporation believes the 20X1 and 20X2 EBITDA targets are probable of

achievement, but the EBITDA target for 20X3 is not.

How should the SC Corporation account for the performance conditions?

Analysis

SC Corporation should measure the fair value of the awards at grant date without regard to the vesting

condition and should recognize compensation cost for the awards that are expected to vest—i.e., the

tranches with an EBITDA target that is probable of being achieved. In this example, SC Corporation

should begin recognizing compensation cost for the first and second tranches. SC Corporation should

reassess the probability of achieving the performance conditions at each reporting period and record a

cumulative catch-up adjustment for any changes to its assessment (which could be either a reversal or

increase in expense).

2.5.3.1 Performance conditions satisfied after the service period

Generally, an award with a performance condition also requires the employee to provide service for a

period of time. The service period can either be explicitly stated in the award or implied such that the

award is forfeited if employment is terminated prior to satisfying the performance condition. In some

circumstances, however, an employee is entitled to vest in and retain an award regardless of whether

the employee is employed on the date the performance target is achieved. In other words, the

employee is not required to provide continued service through the satisfaction of the performance

condition to retain the award.

An example is an award that vests if an employee provides four years of service and the company

completes an IPO. In this example, the employee is not required to be employed at the date of the IPO.

In other words, the employee could terminate his or her employment after four years, but still retain

the right to vest in the award if the company completes an IPO at a later date prior to the expiration of

the award.

Another example is an award with a performance condition granted to an employee who is eligible for

retirement, when the award allows for continued vesting if the performance target is achieved post-

retirement. As discussed in SC 2.6.7, in this fact pattern, the service period ends on the date the

employee is eligible to retire because no further service is required to retain the award.


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Performance targets that affect vesting and could be achieved after the service period should be

accounted for similar to other performance conditions. Therefore, such a condition should not be

reflected in estimating the fair value of the award on the grant date. Rather, compensation cost should

be recognized over the requisite service period (i.e., only the period the employee must provide

service) if it is probable that the performance target will be achieved.

In periods subsequent to the service period, compensation cost is adjusted if the probability

assessment changes. For example, if during the service period, it is not probable the performance

target will be achieved, no compensation cost is recognized. If after the service period is completed, it

becomes probable that the target will be achieved, compensation cost should be recognized

immediately.

Similar to other awards with performance conditions, entities should consider whether the condition

is a substantive vesting condition. For example, if a mechanism exists for the employees to receive

value from the award even if the performance target is never achieved (e.g., through rights to

dividends or dividend equivalents, put or call rights, transferability provisions or other features), the

condition may not be a substantive vesting condition. A condition that is not substantive does not

affect recognition of compensation cost.

Example SC 2-4 illustrates the accounting for an award with a performance condition and an employer

call right.

EXAMPLE SC 2-4

Award with performance condition and employer call right

SC Corporation grants stock options to certain top-level executives that are only exercisable after a

triggering event, such as an IPO (performance condition). However, SC Corporation may call the

option at the intrinsic value upon an employee's termination. If SC Corporation does not call the

option, the individual can continue to hold the option post-termination through the original

contractual term and exercise it if an IPO occurs during that time.

How should SC Corporation account for this award?

Analysis

Typically, the value of an award with a performance condition is recognized when it is probable of

being achieved. A performance condition, such as a successful IPO, is generally not considered

probable until it actually occurs. This would suggest that the expense for these awards would not be

recognized until an IPO occurs. However, the existence of the company's call right upon termination of

employment raises questions about whether the employee's right to receive value from the award or

"vesting" is truly contingent upon the performance condition, or if, in substance, the award always

provides value, either upon termination through the employer call right or upon the trigger event.

While the employee has no rights to demand value from the company (i.e., it is not a put right), the

employee will eventually terminate employment, which would trigger SC Corporation’s call right, and

terminating employment is within the employee's control.

If SC Corporation's intention is to exercise the call feature and pay the departing employee for the

awards (e.g., if SC Corporation does not want any former employees to hold shares and is willing to

provide former employees with liquidity for their awards upon their departure), the award would be


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classified as a liability (as it is probable that SC Corporation will prevent the employee from bearing

the risks and rewards associated with share ownership for a reasonable period of time) and it would in

substance be fully vested upon grant. See SC 3.3.3 for further discussion.

If, however, SC Corporation does not intend to exercise the call feature and can support its intention

not to exercise the call feature, then the grant date fair value of the award would be recognized only

when the performance condition becomes probable, consistent with ASC 718-10-30-28. This would be

appropriate if, for example, SC Corporation does not intend to exercise its call feature and is

comfortable with former employees continuing to hold options. Award holders, whether they are

employees or former employees, will only receive value upon an IPO, if one occurs during the

contractual term of their award.

2.5.4 Performance and service conditions affecting other factors

For performance and service conditions that affect factors other than vesting (e.g., exercise price,

number of shares, conversion ratio, or contractual term), companies should compute a grant-date fair

value for each possible outcome on the grant date. For example, consider an award that has four

different exercise prices based on whether an employee achieves one of four targeted sales thresholds.

Each outcome would have a different grant-date fair value and the company should recognize

compensation cost for the outcome that is probable. This probability assessment should be updated

each reporting period and the company should record a cumulative catch-up adjustment for changes

to the probability assessment. If a company concludes that none of the outcomes are probable, no

compensation cost should be recognized until such time that an outcome becomes probable. The final

measure of compensation cost should be based on the grant-date fair value for the outcome that

actually occurs.

ASC 718 provides guidance on and examples of accounting for awards that have market, performance,

and service conditions that affect factors other than vesting and exercisability (see ASC 718-10-55-64

through ASC 718-10-55-65 and Example 3, Example 4, and Example 6 in ASC 718-20-55-41 through

ASC 718-20-55-67).

Figure SC 2-2 summarizes the key differences among all of the conditions, including certain awards

with common multiple conditions, and their effect on fair value.

Figure SC 2-2 Differences among conditions and their effect on fair value

Condition Effect on grant-date fair value Effect on compensation cost

Market condition affects vesting

Condition considered in the estimate of fair value on the grant date.

Compensation cost is not adjusted if the market condition is not met, so long as the requisite service is provided.

Performance or service condition affect vesting

The performance or service conditions are not reflected in the estimate of fair value on the grant date.

Compensation cost is recognized only for the awards that ultimately vest.


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Condition Effect on grant-date fair value Effect on compensation cost

Performance and market condition affect vesting

If both conditions must be met for the award to vest, the market condition is reflected in the estimate of fair value on the grant date.

Compensation cost is not adjusted even if the market condition is not achieved, so long as performance condition is met and the requisite service is provided.

Performance or market condition affects vesting

The fair value recognized depends on whether the performance condition is achieved. The performance condition would not be reflected in the estimate of the fair value, but the market condition would be. Both amounts should be calculated at the grant date.

Compensation cost is adjusted depending on whether or not the performance condition is achieved. If the performance condition is not probable of being achieved, then compensation cost for the value of the award incorporating the market condition is recognized, so long as the requisite service is provided. If the performance condition is probable or becomes probable of being achieved, the full fair value of the award (i.e., without regard for the market condition) would be recognized.

Market condition affects something other than vesting

The market condition is reflected in the estimate of fair value on the grant date.

Compensation cost is not adjusted if the market condition is not met, so long as the requisite service is provided.

Performance or service condition affect something other than vesting

The fair value on the grant date is determined for each potential outcome.

Compensation cost is based on the grant-date fair value of the award for which the outcome is achieved.

Performance and market condition affect something other than vesting

The fair value on the grant date is determined for each potential outcome of the performance condition and the market condition is reflected in the estimate of fair value for each potential outcome.

Compensation cost is based on the grant-date fair value of the award for which the performance condition outcome is achieved and is not adjusted if the market condition is not met, as long as the performance condition is met.

2.6 Grant date, requisite service period and expense attribution

Under ASC 718, the fair value of stock-based compensation is recognized over the employee’s requisite

service period. This section discusses the determination of the grant date, service inception date, and

requisite service period, expense attribution and how to account for changes in the requisite service

period.


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2.6.1 Grant date for stock-based compensation awards

The fair value of an award is measured on the grant date. For equity awards, the fair value is generally

not remeasured unless there is a modification. For liability-classified awards, the fair value is

remeasured each period until settlement. This difference is summarized in Figure SC 2-3. Refer to SC

3 for further discussion of liability-classified awards.

Figure SC 2-3 Balance Sheet classification

Award classification Measurement effect

Liability Variable—Remeasured at the end of each reporting period, at fair value, until settlement

Equity Fixed—Measured at fair value on the grant date and not remeasured unless the award is modified

A grant date is established when the following criteria are met:

□ The employer and its employees have reached a mutual understanding of the award’s key terms

and conditions.

□ The company is contingently obligated to issue shares or transfer assets to employees who fulfill

vesting conditions.

□ An employee begins to benefit from, or be adversely affected by, subsequent changes in the

employer’s stock price (e.g., the exercise price for an option is known at the grant date). However,

this criterion would not apply if the award does not ultimately depend on subsequent changes in

the stock price, such as fixed dollar awards settleable in a variable number of shares. See SC

3.3.2.3.

□ Awards are approved by the board of directors, management, or both if such approvals are

required, unless perfunctory.

□ The recipient should meet the definition of an employee (i.e., grant date cannot be established

prior to first day of employment) if the award is for employee service.

Awards offered under a plan that is subject to shareholder approval are not considered granted until

the approval is obtained, unless such approval is essentially a formality (or perfunctory). That is, if

management and board members control enough votes to approve the plan, the vote may be

considered perfunctory (i.e., approval may be automatically assumed).

In some situations, the board of directors approves a pool of awards and delegates authority to

management to allocate the pool to individual employees. The awards are not considered “approved,”

as required by the grant date criteria, until management approves the allocation of the pool to

individual employees.


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A mutual understanding of the key terms and conditions of an award exists at the date the award is

approved by the board of directors or other management with relevant authority if the following

conditions are met (ASC 718-10-25-5):

□ The award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate

the key terms and conditions of the award with the employer.

□ The key terms and conditions of the award are expected to be communicated to an individual

recipient within a relatively short time period from the date of approval.

ASC 718-10-25-5(b) provides that “a relatively short time period” should be determined based on the

period during which an entity could reasonably complete the actions necessary to communicate the

terms of an award to the recipients in accordance with the entity’s customary human resource

practices. We believe that “a relatively short time period” should generally be measured in days or

weeks, not months. Companies should consider their individual facts and circumstances to define a

reasonable period of time for communicating to employees, which may be impacted by factors such as

the method of communication (e.g., in person or via e-mail) and the number and geographical location

of employees receiving awards.

Example SC 2-5, Example SC 2-6, and Example SC 2-7 illustrate the determination of the grant date.

These examples do not address whether the service inception date might precede the grant date, as

discussed in SC 2.6.4.

EXAMPLE SC 2-5

Determining grant date – stock options

On January 1, 20X1, SC Corporation approves a stock option award with a vesting period that begins

on February 1, 20X1. All of the recipients are employees that are already providing service as of

January 1, 20X1. All of the terms and conditions of the award are approved on January 1, 20X1 and

communicated to the employees within a relatively short time period, except that the exercise price of

the options will be equal to the market price of SC Corporation’s stock on February 1, 20X1.

What is the grant date of the award?

Analysis

The grant date is February 1, 20X1 because the exercise price of the options is not established until

that date. As a result, the employees do not begin to benefit from, or be adversely affected by,

subsequent changes in the employer’s stock price until February 1, 20X1.

EXAMPLE SC 2-6

Determining grant date – restricted stock

On January 1, 20X1, SC Corporation approves a restricted stock award with a vesting period that

begins on February 1, 20X1. The board of director’s approval states that the award is “granted” as of

February 1, 20X1. All of the recipients are employees that are already providing service as of January 1,

20X1. All of the terms and conditions of the award are approved on January 1, 20X1 and

communicated to the employees within a relatively short time period.


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Analysis

The grant date is likely January 1, 20X1. Even though the board of director’s approval states that the

grant date is February 1, the grant date should be determined based on the grant date requirements in

ASC 718. As of January 1, 20X1, the requirements for establishing a grant date appear to be met as all

of the key terms and conditions have been approved and were communicated within a relatively short

time period. Additionally, because it is a restricted stock award (as opposed to an option with an

unspecified exercise price), the employees begin to benefit from, or be adversely affected by,

subsequent changes in the employer’s stock price on January 1, 20X1.

EXAMPLE SC 2-7

Determining grant date – award authorized prior to first day of employment

SC Corporation offers the position of CEO to an individual on April 1, 20X1, which has been approved

by the board of directors. In addition to offering a salary and other benefits, SC Corporation offers

10,000 shares of restricted stock that the prospective CEO would vest in upon completing five years of

service. The CEO begins vesting in the award on the date that he begins work.

The individual accepts the CEO position on April 2, 20X1, but does not begin providing services until

June 2, 20X1.


Analysis

The grant date is June 2, 20X1, when the individual begins employment because the award is for

employee service.

2.6.1.1 Grant date for awards with performance conditions

A mutual understanding of the terms and conditions does not exist if the award has a performance

condition, but the performance target has not yet been defined. For example, if the performance target

has not yet been approved or the target is based on a budget that is not yet approved, the grant date

requirements are not met until such approval is obtained. The performance targets also must be

communicated to employees (or communicated within a “relatively short time period,” as discussed in

SC 2.6.1).

To establish a grant date, performance targets should be objectively determinable and measurable. For

example, a mutual understanding of the terms and conditions might not exist if the compensation

committee has the ability to adjust, at its discretion, how performance against the performance target

will be measured. When assessing if the discretion by the compensation committee (or others with

authority over the compensation arrangement) impacts the grant date determination, a company

should consider:

□ How often the compensation committee has made adjustments in the past and the nature of those

adjustments


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□ Whether there are objective criteria for making adjustments to an award

□ Whether the holders of the award have an understanding of when and how the terms of the award

will be adjusted

Conditions based on the employee's individual performance also need to be clear and objective. If

targets are based on employee evaluations and performance ratings, the evaluation process should be

well-controlled and understood by the employee, be reasonably objective, and serve as a basis for

promotion and other compensation decisions. Otherwise, the grant date criteria would not be met

until the performance evaluation is completed.

Example SC 2-8 and Example SC 2-9 illustrate the determination of a grant date for awards with

performance conditions.

EXAMPLE SC 2-8

Determining grant date for an award with a performance condition

On January 1, 20X1, SC Corporation grants options to employees that vest in three tranches based on

achieving an EBITDA target in each of the next three years (20X1, 20X2, and 20X3). The target for

each year will be approved by the board of directors on January 15 of the respective year. For example,

the EBITDA target for 20X1 (the first tranche) is approved on January 15, 20X1. The EBITDA target

will be communicated to employees shortly after the approval date. Assume all other terms and

conditions of the award are approved as of January 1, 20X1.


Analysis

Each tranche of the award has a separate grant date, which is the date the EBITDA target is approved

by the board of directors. While there may be a process in place to approve EBITDA targets, because

the board of directors has discretion in determining and approving the target, a mutual understanding

of the terms and conditions does not exist until the target is approved. The first, second, and third

tranches will have a grant date of January 15, 20X1, January 15, 20X2, and January 15, 20X3,

respectively.

EXAMPLE SC 2-9

Determining grant date – award with multiple performance targets

On January 1, 20X2, SC Corporation grants restricted stock to an executive that vests at the end of the

year based on continued service and achieving the following performance targets:

□ 50% of the shares vest if total revenue growth for 20X2 exceeds 10% as compared to 20X1

□ 50% of the shares vest if the holder of the award achieves “satisfactory progress in developing new

products” for the executive’s business unit

SC Corporation’s process for evaluating “satisfactory progress in developing new products” is highly

subjective and the executive is not provided clear guidelines or objective criteria for meeting the target.

The decision about whether the target is met will be made by the compensation committee.


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Analysis

Based on the facts provided, the grant date for the 50% portion of the award that vests based on

revenue growth is January 1, 20X2. Even though the executive does not yet know the actual dollar

amount of revenue required to achieve the target (as the financial statements for 20X1 have not yet

been prepared and total revenue for the year is not yet known), how revenue growth will be calculated

is known and objectively determinable and therefore, there is a mutual understanding of the terms

and conditions.

However, a grant date for the 50% portion of the award for which vesting depends on satisfactory

progress in developing new products will not occur until the compensation committee determines

whether the target has been met. This is because there is not a mutual understanding of the terms and

conditions of this portion of the award given the highly subjective process for evaluating whether the

target has been met.

2.6.2 Requisite service period for stock compensation awards

The fair value of stock-based compensation is recognized in a company’s financial statements over the

requisite service period through a charge to compensation cost and a corresponding increase to

additional paid-in capital or to a liability, depending on the classification of the award. The requisite

service period is the period during which an employee is required to provide service in exchange for

stock-based compensation. It could be explicit, implicit, or derived, depending on the terms of the

award.

The requisite service period generally commences on the grant date. However, initial recognition of

compensation cost may precede the grant date or begin after the grant date in certain circumstances

(as discussed in SC 2.6.4 and SC 2.6.5). Additionally, if an award requires future service, the requisite

service period is presumed to be only for the future service and expense is recognized prospectively.

Therefore, a company cannot conclude that a period before the earlier of the service inception or grant

date is part of an award’s requisite service period. However, for an award that is fully vested on the

grant date, all compensation cost would be recognized on the grant date.

The requisite service period should be based on an analysis of the award’s terms, as well as other

relevant facts and circumstances (e.g., employment agreements, company prior practice). ASC 718-10-

55-109 through ASC 718-10-55-115 provides additional details on determining the requisite service

period and includes several examples.

Figure SC 2-4 provides definitions and examples of the terms used in ASC 718 to assist in determining

the requisite service period.


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Figure SC 2-4 Definitions and examples of a requisite service period

Definitions Examples Requisite service period

Explicit service period is stated in the terms of the stock-based compensation award.

An award will vest after four years of continuous service that starts on the grant date.

The award has an explicit service period and a requisite service period, comprising four years.

Implicit service period is inferred from an analysis of other terms in the award, including explicit performance or service conditions.

An award will vest upon the completion of a new product’s design that is expected to be finished in 36 months.

The implicit requisite service period is 36 months.

Derived service period is determined based on certain valuation techniques that are used to estimate fair value. This principally applies to awards that have market conditions.

An award will become exercisable if the stock price increases by 100% at any time during a five-year period.

The requisite service period can be derived from a lattice model that is used to estimate fair value.

The requisite service period for an award with a market condition may be derived through certain

valuation techniques (e.g., a lattice model). See SC 8.5 for a description of a lattice model. The

valuation technique is summarized below:

□ In a lattice model, the derived service period represents the duration of the median (as defined in

the next two bullets) of the distribution of stock-price paths on which the market condition is

satisfied.

□ The duration is the period of time from the service inception date to the expected date that the

market condition will be satisfied (as inferred from the valuation technique).

□ The median is the middle stock-price path (the mid-point of the distribution of paths) on which

the market condition is satisfied.

The requisite service period for an award with a service condition may be a derived service period if

the award is deep out-of-the-money on the grant date. In that situation, the explicit service period of

the award may not be substantive because the employee may be required to provide service for some

period of time in order to obtain any value from the award (if retention of the award is effectively

contingent on employment because it has a short period of time during which it can be exercised after

termination). If a deep out-of-the-money award is determined to also have a derived service period,

the requisite service period should be based on the longer of the explicit service period and the derived

service period. Generally, the derived service period of a deep out-of-the-money award would be

determined by using a lattice model because the award effectively contains a market condition.

Figure SC 2-5 summarizes how an award’s requisite service period may be determined based on the

nature of the vesting condition that the award contains.


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Figure SC 2-5 Determining requisite service based on an award’s condition

Nature of condition Potential type of requisite service period

Service condition Explicit or derived

Performance condition Explicit or implicit

Market condition Explicit or derived

Throughout this guide, the terms “vested” and “partially vested” are generally used to describe awards

for which the employee has completed the requisite service period or partially completed the requisite

service period, respectively. As used within this guide, “vested” or “partially vested” may not be

equivalent to legally vested, which represents the date or event upon which the employee has fulfilled

the vesting condition and can terminate service from the employer and retain the award.

2.6.3 Expense attribution for stock-based compensation awards

Under ASC 718-10-35-2, compensation cost for an award of share-based compensation is recognized

over the requisite service period. This is generally referred to as the “attribution of expense.”

Example SC 2-10 illustrates the attribution of expense.

EXAMPLE SC 2-10

Expense recognition when vesting begins before the grant date

On April 1, 20X1, SC Corporation’s compensation committee approves a stock option award for certain

members of management. The options vest 25% each year over a four-year period beginning on

January 1, 20X1 (e.g., the first tranche will vest on December 31, 20X1) based only on continued

service. The grant date of the options is April 1, 20X1 because approval of the options was obtained

and all terms and conditions were known on that date. The service inception date is also April 1, 20X1

because the requirements to establish a service inception date prior to the grant date have not been

met. Accordingly, SC Corporation did not record any compensation cost related to the options prior to

April 1, 20X1.

The total grant-date fair value of the award is $100,000 and the options are equity-classified. SC

Corporation’s policy is to use the straight-line attribution approach to recognize compensation cost for

options with graded vesting features and only service conditions.

Should SC Corporation record a "catch-up" entry on April 1, 20X1 to account for the shortened vesting

period in the first year (i.e., the vesting "credit" given for the three months prior to the grant date)?


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Analysis

No. SC Corporation should record compensation cost prospectively beginning on the grant date. ASC

718 requires compensation cost to be recognized over the requisite service period. The definition of

requisite service period states that if an award requires future service for vesting, a company cannot

define a prior period as the requisite service period. Therefore, SC Corporation should not record a

"catch-up" entry on April 1, 20X1.

However, SC Corporation will need to consider the requirement in ASC 718-10-35-8 that the amount

of compensation cost recognized at any date must at least equal the portion of the grant-date value of

the award that is legally vested (the "floor" concept). When the first tranche of options vests on

December 31, 20X1, SC Corporation should ensure it has recorded at least $25,000 ($100,000 x 25%)

of compensation cost related to the award. Therefore, it would be appropriate for SC Corporation to

anticipate the "floor" before the legal vesting "trigger" is met and recognize $25,000 of compensation

cost ratably over the period from April 1, 20X1 through December 31, 20X1. The remaining $75,000 of

compensation cost would be recognized over the period from January 1, 20X2 through the final

vesting date.

2.6.4 Service inception date – prior to grant date

The “service inception date” is the first day of the requisite service period and the date on which a

company would begin to recognize compensation cost. If the following criteria are satisfied, the service

inception date could precede the grant date (ASC 718-10-55-108 through ASC 718-10-55-109):

□ An award is authorized.

□ Service begins before there is a mutual understanding of the key terms and conditions of a stock-

based compensation award (e.g., an employee providing service is granted an award where the

exercise price will be set at a future date).

□ Either of the following conditions exist:

o The plan or award’s terms do not include a substantive future requisite service condition onthe grant date (e.g., at the grant date the award is vested).

o The plan or award contains a market or performance condition that if not satisfied during theservice period preceding the grant date and following inception of the arrangement results inforfeiture of the award (refer to ASC 718-10-55-114).

For example, an award’s service inception date may precede the grant date when a vested award is

issued to an employee but the exercise price is set at a later date. The award’s grant date would be the

first date on which the exercise price and the current stock price are known to provide a sufficient

basis for the employee to understand and bear the risks and rewards of equity ownership.

In contrast, if an unvested award with only a service condition is awarded with an exercise price to be

determined at a later date and the award requires the employee to provide future service after the date

the exercise price is determined, the service inception date would not precede the grant date because

the award requires substantive future service. In this scenario, both the service inception date and the

grant date would be the date on which the exercise price is known.

If it is determined that the service inception date precedes the grant date, a company should accrue

compensation cost beginning on the service inception date. The company should estimate the award’s


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fair value on each subsequent reporting date (i.e., remeasure each period at fair value) until the grant

date. On the grant date, the estimate of an equity-classified award’s fair value is fixed; therefore, the

cumulative amount of previously-recognized compensation cost should be adjusted to the grant date

fair value, and the company would no longer remeasure the award. If the award is liability classified, it

would continue to be marked to fair value each reporting period until settlement.

If an award is cancelled and replaced with a new award during the period prior to the grant date, the

company would remeasure fair value as of the issuance of the new award and adjust the cumulative

amount of previously-recognized compensation cost.

Figure SC 2-6 summarizes the criteria for establishing the service inception date prior to the grant

date.

Figure SC 2-6 Summary of service inception date criteria

* The reference to the plan in ASC 718-10-55-108 is based on our view that a company could elect to interpret these criteria in

the context of the plan as a whole, as opposed to individual awards.

Example SC 2-11 illustrates the determination of whether the service inception date criteria are met.

EXAMPLE SC 2-11

Service inception date – assessing whether the award is authorized

On January 1, 20X1, SC Corporation's board of directors approves an overall compensation plan that

includes terms of performance awards to be granted to employees. The performance awards are based

on SC Corporation achieving an EBITDA target during 20X1. The employees will vest in the awards if

the target is achieved and the employees provide service for two additional years (i.e., through


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December 31, 20X3). At the time of board approval, the employees are aware of the compensation

plan, and that if the EBITDA target is achieved an award will be granted. However, other key terms

and conditions, such as the number of awards allocated to each employee, will not be communicated

until the end of 20X1. As a result, the grant date criteria are not met until December 31, 20X1.

Are the service inception date criteria met as of January 1, 20X1?

Analysis

It depends. The employees are beginning to provide service and the award contains a performance

condition (EBITDA target) that must be achieved prior to the grant date. However, the assessment of

whether the award has been authorized requires judgment and careful assessment of the facts and

circumstances. A broad interpretation of “authorization” could result in a conclusion that the awards

are authorized as of January 1, 20X1 even though the number of awards allocated to each employee

has not yet been finalized. This interpretation is based on the fact that (1) the board of directors has

approved an overall compensation plan that includes the stock-based compensation awards, and (2)

the employees broadly understand the compensation plan, including an awareness that if certain goals

are met, there is an expectation that awards will be granted.

Additional factors that may be important to the analysis might include:

□ Whether the compensation plan summarizes the process of how awards will be allocated to the

employees and how the number of awards or monetary amount of the awards will be determined

(e.g., based on certain performance metrics that are defined or understood either through formally

authorized policy or established practices).

□ The substance of the approval process to finalize the award, including the amount of discretion

that the board of directors has to deviate from the previously-approved compensation plan.

Under a narrow interpretation, SC Corporation might conclude that the awards have not been

authorized as of January 1, 20X1 because the number of awards granted to individual employees has

not yet been authorized.

Although each set of facts and circumstances is unique, in general, we believe that the use of the broad

or narrow interpretation described in Example SC 2-11 is an accounting policy and should be applied

consistently to all similar awards.

2.6.5 Service inception date–after grant date

The service inception date can also occur after the grant date. Typically, as of the grant date, an

employee has begun providing service toward earning an award and therefore, a company should

begin recording expense. However, ASC 718-10-55-94 provides an example of a situation when the

service inception date is after the grant date. In that example, there is an award consisting of four

tranches with the same grant date and four separate annual performance targets. The employee vests

in each tranche based on achieving the annual performance target and providing service during the

respective year. The example concludes that each tranche should be accounted for as a separate award

with its own service inception date as of the beginning of the year to which the performance condition

relates. The conclusion is based on the following factors:


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□ Each tranche contains an independent annual performance condition that relates to service during

the respective separate annual period.

□ The employee’s ability to vest in each tranche is not dependent on service beyond the related year.

□ The failure to satisfy the performance condition in any one particular year has no effect on the

vesting of any preceding or subsequent period’s tranche.

We believe this conclusion should only be applied to fact patterns in which all of the above factors are

present.

2.6.6 Service completion date for stock-based compensation awards

The requisite service period generally ends on the service completion date. The service completion

date occurs when an employee completes the requisite service period (i.e., the employee is no longer

required to provide any additional service to retain the award). For example, for an award with an

explicit service condition, the service completion date is the final date that an employee is required to

be employed by the company in order to retain the award. In contrast, the service completion date for

an award with an implicit performance condition would be the date that an employee achieves the

target specified in the award’s terms while being employed by the company. The service completion

date of an award with a market condition is usually the earlier of (1) the date on which the market

condition is satisfied or (2) the date on which the derived service period is completed, even if the

market condition is not satisfied.

2.6.7 Awards with accelerated vesting upon retirement

Many companies have plans with terms that provide for the immediate vesting of an employee’s

awards when the employee retires (e.g., defined parameters for eligible retirements, such as the sum of

age and years of service), sometimes with immediate exercisability or alternatively, with exercisability

following the original vesting schedule. In those cases, the service completion date is the date that the

employee is eligible to retire, not the probable or actual date of retirement, because the employee is

not required to provide any future service beyond that eligibility date in order to retain the award.

For awards granted to retirement-eligible employees where no service is required for the employee to

retain the award, application of ASC 718-10-55-87 through ASC 718-10-55-88 results in the immediate

recognition of compensation cost at the grant date because the employee is able to retain the award

without continuing to provide service. This may also be relevant in assessing whether a service

inception date has been achieved prior to grant date (see SC 2.6.4). For employees near retirement

eligibility, attribution of compensation cost should be over the period from the grant date to the

retirement eligibility date.

A company should consider other terms of an award that could impact the date the employee is eligible

to retire, such as a required notice period. For example, if a retirement-eligible employee must provide

six months’ notice before their retirement date, the initial service period is six months. We believe a

company could recognize all of the compensation expense over six months in this fact pattern.

Alternatively, the company could continuously update its estimate of the service period each reporting

period if the employee has not yet given notice (i.e., the revised estimate would extend six months

from the reporting date), with updates to the estimate accounted for on a prospective basis. A

company should apply its policy consistently to similar awards. It would not be appropriate for a


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company to estimate when they expect the employee to retire and recognize compensation expense

over that estimated period.

Unlike the attribution of compensation cost, when estimating the probable retirement date would be

inappropriate, the expected vesting (i.e., retirement) date, as well as expected exercise behavior, will

be necessary to determine the expected term assumption in measuring the fair value of the award.

2.6.8 Noncompete provisions in stock-based compensation awards

In some situations, compensation arrangements may contain noncompete provisions. Under a typical

noncompete provision, the employee may be required to return the award (or the cash equivalent) if

the employee terminates employment with the company and is subsequently employed by a

competitor during the term of the noncompete agreement. Examples 10 and 11 of ASC 718-20-55-84

through ASC 718-20-55-92 illustrate the accounting for stock-based compensation awards that include

noncompete provisions.

In Example 10, the FASB concluded that the noncompete provision does not compel the employee to

provide service and therefore does not affect the requisite service period. This noncompete provision is

treated as a clawback feature, which is accounted for if and when the employee violates the

noncompete provision and the award or the cash equivalent are returned. Thus, the compensation cost

associated with the award is recognized based on the stated vesting terms, without consideration of the

noncompete agreement. If the award is fully vested upon issuance, or if the recipient is retirement-

eligible, compensation cost is recognized immediately.

Conversely, in Example 11, the FASB concluded that the noncompete provision essentially creates an

in-substance requisite service period because the facts and circumstances indicate that the employee

was essentially in the same position as they would have been if an explicit vesting period had existed.

In other words, the noncompete provision functions as an in-substance vesting condition. In this

example, even if the award was fully vested, or the recipient was retirement eligible, compensation cost

would be recognized over the term of the noncompete agreement.

A noncompete provision creates an in-substance requisite service period if it compels the employee to

continue providing service to the company in order to receive the award. The fact that the noncompete

provision is substantive is not, by itself, sufficient to conclude that the provision compels the employee

to remain in active service.

When assessing the impact of noncompete provisions, companies should consider:

□ The amount of the stock-based compensation award as compared to the employee’s other

compensation. In Example 11 of ASC 718-20-55-87 through ASC 718-20-55-92, the stock-based

compensation award has a value that is four times greater than the employee’s annual cash

compensation. The greater the relative value of the stock-based compensation award, the more

likely it is that the employee would continue to provide service to the company in order to receive

the award.

□ The severity of the effect of the noncompete agreement on the employee’s ability to gain

employment elsewhere.

□ The company’s intent and ability to enforce the noncompete and the company’s past practice of

enforcing noncompete agreements.


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□ The ability of the employee to obtain access to the award (e.g., whether the award is subject to a

delayed-transfer schedule that coincides with the period of the non-compete agreement).

□ Employer’s past practice with respect to employees who may have violated the noncompete

agreements (if relevant).

□ Circumstances specific to the individual employees.

In our experience, most noncompete provisions do not create an in-substance service condition. This

may be an appropriate presumption unless there is persuasive evidence that the provision compels the

employee to remain in active service to receive the award. We expect that instances when a

noncompete provision creates an in-substance service condition will be rare.

2.6.9 Multiple service periods in stock-based compensation awards

Awards with multiple market, performance, or service conditions may have terms that specify multiple

service periods. For accounting purposes, however, an award can have only one requisite service

period.

A company should develop its estimate of the requisite service period based on an analysis of (1) all

vesting and exercisability conditions, (2) all explicit, implicit, and derived service periods, and (3) the

probability that performance or service conditions will be satisfied (ASC 718-10-55-72). Figure SC 2-7

summarizes this analysis.

Figure SC 2-7 Determining a requisite service period for an award with multiple explicit, implicit, or derived service

periods

Conditions Requisite service period

□ Market condition

and

□ Either performance or service conditions

that are probable of being satisfied

Longest of the explicit, implicit, or derived service periods, because all of the conditions need to be satisfied.

□ Market conditions

or

□ Either performance or service conditions

that are probable of being satisfied

Shortest of the explicit, implicit, or derived service periods, because vesting occurs upon satisfaction of any of the award’s conditions.

If an award contains both a market and a performance condition, but the performance condition is not

probable of being satisfied, compensation cost is not recognized until the performance condition

becomes probable. An example is an award granted by a nonpublic company that vests only upon a

liquidity event (performance condition — e.g., an initial public offering or change in control) and the

achievement of a specified internal rate of return (IRR) to the existing principal shareholder (typically,

a private equity firm) (market condition). As discussed in SC 2.5.3, the liquidity event would not be

considered probable until the date it occurs. Therefore, no compensation cost would be recognized

related to this award until the liquidity event occurs. At that date, compensation cost equal to the


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grant-date fair value (assuming all criteria for equity classification are met) would be recorded,

regardless of whether the market condition is satisfied.

2.6.10 Changes to the requisite service period of awards

A company may change its initial estimate of the requisite service period based on the original terms of

the award. See SC 4.3.6 for a discussion of modifications to an award that may affect the award’s

requisite service period.

Figure SC 2-8 summarizes when a company can change its estimate of the requisite service period for

an equity-classified award, as described in ASC 718-10-55-77 through ASC 718-10-55-79.

Figure SC 2-8 Changes to the requisite service period for an equity-classified award

Basis for initial estimate of the requisite service period

Required change to the requisite service period

Performance or service condition Change the requisite service period if subsequent information indicates that:

□ It is probable that the performancecondition will be achieved within a differenttime period

or

□ Another performance or service conditionbecomes the probable outcome

Market condition Do not change the requisite service period unless the market condition is satisfied before the end of the initially estimated requisite service period

Market condition and a performance or service condition

[The initial estimate of the requisite service period is based on the market condition’s derived service period.]

Do not change the requisite service period unless:

□ The market condition is satisfied before theend of the derived service period

or

□ Satisfying the market condition is no longerthe basis for determining the requisiteservice period

The requisite service period for a liability-classified award is generally updated each reporting period

in conjunction with the remeasurement of the award.

We believe that for liability-classified awards with market conditions that have a derived service

period, there are two acceptable alternatives that can be applied:


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□ Periodic update method: Revise the remaining service period each reporting period in conjunction with the remeasurement of the award.

□ Grant date method: Do not update the service period; in other words, the estimate of the requisite service period at the grant date (or service inception date if that date precedes the grant date) is not changed in future periods when the lattice model is updated for changes in measuring the fair value of liability-classified awards.

The choice of an approach is an accounting policy election that must be applied consistently.

2.6.11 Recognition effect of changes to requisite service period

As Figure SC 2-8 describes, a company may change its initial estimate of requisite service period in

certain circumstances. However, not all such changes are treated the same:

□ If either the quantity or grant-date fair value of an award changes because another performance or

service condition becomes probable of satisfaction (e.g., the performance condition affects exercise

price), that change will be accounted for as a “cumulative effect” (for the portion of the requisite

service period that has been rendered) on both current and prior periods in the period of the

change.

□ If an initially estimated requisite service period changes solely because another market,

performance, or service condition becomes the basis for the requisite service period, any

unrecognized compensation cost at that date will be recognized prospectively over the revised

requisite service period, if any (i.e., no “cumulative effect” adjustment recognized).

Example SC 2-12, Example SC 2-13 and Example SC 2-14 illustrate how a company should consider

necessary adjustments to the requisite service period over the life of the award, based on the type of

vesting condition.

EXAMPLE SC 2-12

Changes to the requisite service period for an award with service and performance conditions

On January 1, 20X1, SC Corporation grants two executives a total of 100,000 stock options. The grant-

date fair value is $10 per option. The terms of the award specify that the award will vest if both of the

following conditions are satisfied: (1) the completion of a new product design (i.e., a performance

condition) and (2) the executive is employed on the date the new product design is completed (i.e., a

service condition). At the grant date, SC Corporation determines that it is probable that the new

product design will be completed two years from the grant date. SC Corporation also believes the

executives will be employed on that date.

What is the appropriate requisite service period?

Analysis

When determining the requisite service period, SC Corporation must assess the probability that the

performance condition will be satisfied. As it is probable both of the conditions will be met, the

requisite service period would be two years. SC Corporation would recognize $500,000 ($10 fair value

× 100,000 options = $1,000,000 ÷ 2-year service period) of compensation cost each year.


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Because the award has a performance condition, SC Corporation must reassess the probability of

satisfaction of the performance condition each reporting period. If a year after the grant date, SC

Corporation determines that it is now probable that the performance condition will be satisfied in

three years (i.e., two years from the current date and one year longer than originally estimated), SC

Corporation must adjust its accounting for the awards.

Assuming it is probable that the executives will employed for the next two years, the remaining

requisite service period would be two years, as compared to the one year remaining requisite service

period based on SC Corporation’s original estimate.

The change in the requisite service period affects only the attribution of expense. The fair value of the

award is not remeasured. Therefore, SC Corporation should account for the change in estimated

requisite service period prospectively. SC Corporation should record the remaining unrecognized

compensation cost of $500,000 over the remaining two years of the updated requisite service period

($250,000 each year).

EXAMPLE SC 2-13

Changes to the requisite service period for an award with service and market conditions

On January 1, 20X1, SC Corporation grants two executives a total of 100,000 stock options. The terms

of the award specify that the award will vest upon the earlier of (a) the stock price reaching and staying

at a minimum of $100 per share for 60 consecutive trading days (i.e., a market condition) or (b) the

completion of five years of service (i.e., a service condition).

What is the appropriate requisite service period?

Analysis

Because the award has a market condition, the company uses a lattice model to estimate the award’s

fair value and determine if the derived service period is shorter than the explicit service condition. The

company derives its estimate of the award’s service period from the lattice model’s results, which in

this case is three years. Therefore, the requisite service period over which compensation cost should be

attributed is the market condition’s derived service period of three years (rather than the five-year

service period) because it is the shorter requisite service period.

Because the award has a market condition, the requisite service period is not revised unless the market

condition is satisfied before the end of the derived service period. If the market condition is satisfied in

only two (not three) years, the company should immediately recognize any unrecognized

compensation cost, because the executives do not have to provide any further service to earn the

award. Alternatively, if the market condition is not satisfied but the executives render the three years

of requisite service, compensation cost should not be reversed.

EXAMPLE SC 2-14

Changes to the requisite service period for an award with a vesting acceleration clause

On January 1, 20X1, SC Corporation grants an executive 40,000 stock options. The grant-date fair

value is $10 per option. The terms of the award specify that the award will cliff vest if the executive is

employed at the end of a four-year service period. Vesting will also be accelerated if the executive is

terminated by the company without cause. At the grant date, it is probable that the four-year service


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condition will be achieved. However, at the beginning of 20X2, SC Corporation determines that it will

terminate the executive without cause by June 30, 20X2.

What is the appropriate requisite service period? What is the impact of the decision to terminate the

executive?

Analysis

The four-year vesting provision is a service condition. Additionally, as described in ASC 718-10-20,

acceleration of vesting in the event of an employee’s death, disability, or termination without cause is

also considered a service condition. Since there are two potential service conditions (only one of which

needs to be satisfied), SC Corporation would evaluate the different conditions and determine which

one(s) are probable of achievement, and then use the shortest of those periods as the initial requisite

service period. As of the grant date, SC determined that it was probable that the four-year service

condition would be achieved, and it was not probable that an involuntary termination would occur.

Therefore, SC Corporation began to recognize the grant-date fair value over the initial four-year


As required by ASC 718-10-55-77, SC Corporation should reassess the probability of the different

vesting conditions and adjust its estimate of the requisite service period as those assessments change.

When it becomes probable that SC Corporation intends to terminate the executive (which will trigger

the automatic acceleration feature), the service condition associated with the termination without

cause becomes probable of being satisfied. As the remaining period until this vesting date (estimated

to be 6 months) is shorter than the remaining 3 years in the original four-year vesting period, the

requisite service period should be changed to the shorter period. Consistent with ASC 718-10-55-78

and ASC 718-10-55-79, SC Corporation would recognize any remaining unrecognized compensation

cost for the award prospectively over the revised requisite service period (i.e., no “cumulative effect”

adjustment is recognized). The fair value of the award is not remeasured. The change in the requisite

service period affects only the attribution of expense going forward. Therefore, SC Corporation would

record the remaining unrecognized compensation cost of $300,000 over the remaining 6-month

estimated requisite service period.

2.7 Estimates and adjustments for forfeitures

Companies should make an accounting policy election to either estimate forfeitures or to account for

them when they occur.

For purposes of this guide, “pre-vesting forfeiture” describes the circumstance when an award is

forfeited prior to vesting, for example due to termination or failure to satisfy a performance condition.

A “post-vesting cancellation” describes the circumstance when an employee terminates after vesting

and does not exercise their vested award or if a vested award expires unexercised at the end of its

contractual term. This distinction is important because a pre-vesting forfeiture results in reversal of

compensation cost whereas a post-vesting cancellation would not. Additionally, as discussed in SC 9.3,

the development of the expected term assumption does not consider pre-vesting forfeitures but does

consider post-vesting cancellations.


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2.7.1 Estimating forfeitures

Companies may make a company-wide accounting policy election to estimate forfeitures of employee

awards. Under ASC 718, if a company has a policy to estimate forfeitures, then it is required to develop

an assumption regarding the pre-vesting forfeiture rate beginning on the grant date. The forfeiture

estimate impacts the estimated amount of compensation expense to be recorded over the requisite

service period. Companies are required to true-up forfeiture estimates for all awards with performance

and service conditions through the vesting date so that compensation cost is recognized only for

awards that vest (ASC 718-10-35-3). For awards with market conditions, a forfeiture rate assumption

is applied to adjust compensation cost for those employees that do not complete the requisite service

period. However, compensation cost is not reversed if the company fails to satisfy the market

condition.

Under ASC 718-10-35-3, companies that estimate forfeitures will (1) estimate the number of awards

for which it is probable that the requisite service will be rendered and (2) update that estimate as new

information becomes available through the vesting date. A company should also review its forfeiture-

rate assumption for reasonableness at least annually and potentially on a quarterly basis, considering

both forfeiture experience to date and a best estimate of future forfeitures of currently outstanding

unvested awards. It should also review its forfeiture-rate assumption when significant events occur

which could affect the likelihood of employees vesting in outstanding awards, such as planned

restructuring actions.

Under ASC 718-10-35-8, the amount of compensation cost that is recognized on any date should at

least equal the grant-date fair value of the vested portion of the award on that date. If a company

applies a forfeiture-rate assumption that assumes more forfeitures than actually occur, the company

may not be recognizing enough compensation cost to meet this requirement. Accordingly, for awards

that vest in separate tranches, companies should assess, as each tranche vests, whether the

compensation cost recognized for the award at least equals the vested portion of that award.

2.7.1.1 Election to account for forfeitures as they occur

Companies may also make a company-wide accounting policy election to account for forfeitures of

employee awards as they occur. The policy election only relates to the service condition aspects of

awards; entities will still need to assess the likelihood of achieving performance conditions each

reporting period.

A company that elects to account for forfeitures as they occur will record compensation cost assuming

all option holders will complete the requisite service period. If an employee forfeits an award because

they fail to complete the requisite service period, the company will reverse compensation cost

previously recognized in the period the award is forfeited. Thus, the total cumulative amount of

compensation cost recognized for an award will be the same regardless of whether the company elects

to estimate forfeitures or account for forfeitures as they occur.

There are certain circumstances where it will still be necessary to estimate forfeitures:

□ If an award is modified, the company should assess whether the performance or service conditions

of the original award are expected to be satisfied when measuring the effects of the modification

(refer to SC 4). The company should apply its accounting policy to account for forfeitures when

they occur upon subsequent accounting for the modified award.


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□ If an award is exchanged or replaced in connection with a business combination, forfeitures must

be estimated to attribute the acquisition date fair value of the replacement awards between pre-

combination service (which is included as part of the consideration exchanged in a business

combination), and the amount attributable to post-combination service (which is recorded as

compensation cost). The amount attributed to precombination service is reduced for awards that

are expected to be forfeited. See BCG 3.4.1 for further discussion of the fair value attributable to

pre- and post-combination service in the exchange of share-based awards in a business

combination.

Example SC 2-15 illustrates the recognition of forfeitures as they occur.

EXAMPLE SC 2-15

Recognition of forfeitures as they occur

On January 1, 20X1, SC Corporation grants a restricted stock award to its CEO that vests on December

31, 20X3 based on providing continued service over that period. SC Corporation has elected a policy to

account for forfeitures as they occur.

On December 1, 20X2, the CEO informs the board of directors of her intent to voluntarily terminate

her employment effective January 31, 20X3.

When should SC Corporation reverse previously recognized compensation cost for the award?

Analysis

SC Corporation should reverse previously-recognized compensation cost in the period the award is

forfeited, which is January 20X3. Although as of December 31, 20X2 it is expected the award will be

forfeited, SC Corporation has elected to account for forfeitures as they occur. Therefore, SC

Corporation should not adjust compensation cost in its 20X2 financial statements. Further,

compensation cost should continue to be recognized through the date of actual forfeiture. SC

Corporation should consider whether disclosure of the anticipated termination and the related

financial statement impact is warranted in the 20X2 financial statements.

2.7.2 Forfeitures and liability-classified awards

For companies that elect to estimate forfeitures, a forfeiture assumption (considering forfeiture

experience to date and estimating future forfeitures) should be applied to awards that are classified as

liabilities as well. Liability awards are remeasured at fair value each reporting period, and any impact

of forfeitures or updates to the forfeiture estimate, although not affecting the fair value measurement

of the awards, should be reflected at that time as well.

2.7.3 Applying a forfeiture-rate assumption

For companies that elect to estimate forfeitures, the forfeiture-rate assumption is typically expressed

as the estimated annual rate at which unvested awards will be forfeited during the next year, which

may or may not differ significantly by employee group. Some companies estimate the total forfeitures

for the entire grant or for each vesting tranche. The forfeiture-rate assumption can be based on a

company’s historical forfeiture rate if known. However, management should assess whether it is

necessary to adjust the historical rate to reflect its expectations. For example, adjustments may be


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needed if, historically, forfeitures were affected mainly by turnover that resulted from business

restructurings that are not expected to recur.

Companies could use separate pre-vesting forfeiture assumptions for different employee groups when

they believe those groups will exhibit different behaviors. For example, based on its history and

expectations, a company may develop a 5% annual forfeiture estimate for senior executives and a 10%

annual forfeiture estimate for all other employees.

Example SC 2-16 illustrates how a company could apply its estimated annual forfeiture rate to an

option grant.

EXAMPLE SC 2-16

Estimated annual forfeiture rate applied to an option grant

SC Corporation grants to its employees a total of 400 stock options that (1) vest upon the employees’

completion of a service condition and (2) have a four-year graded vesting schedule (25% or 100 awards

per year). SC Corporation estimates a 5% annual forfeiture rate, based on its historical forfeitures. SC

Corporation uses the following calculations to determine the number of options that are expected to

vest:

Year Number of options eligible for vesting

Number of options expected to vest Calculation

1 100 95 = 100 × .95

2 100 90 = 100 × .95 × .95

3 100 86 = 100 × .95 × .95 × .95

4 100 81 = 100 × .95 × .95 × .95 × .95

Totals 400 352

How much compensation expense should SC Corporation recognize in year 1?

Analysis

In this example, 88% of the options are expected to vest (352 options expected to vest/400 options

granted). As discussed in SC 2.8, for awards with graded vesting features, companies will use either a

graded vesting (accelerated) or straight-line attribution approach to recognize compensation cost over

the vesting period. If a company uses an annual forfeiture rate for awards with graded vesting, as

illustrated above, and the straight-line attribution approach to recognize compensation cost, there

could still be some compensation cost that is front-loaded to the beginning of the requisite service

period. In this case, SC Corporation would begin expensing 95 options in year 1 under the straight-line

attribution approach, rather than 88 options, because of the requirement to expense at a minimum the

number of awards actually vested at each vesting date.

As each tranche vests, a company should assess the actual number of awards vested in order to comply

with the requirement that the amount of compensation cost that is recognized on any date should at

least equal the grant-date fair value of the vested portion of the award. For example, if all 100 options

vest in the first year in the above scenario (i.e., no awards are forfeited in the first year), the company

should recognize compensation cost for those 100 awards. Additionally, the company will need to re-


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evaluate the number of unvested options remaining and the reasonableness of the forfeiture-rate

assumption used for the remaining requisite service period.

Other approaches for determining and applying a forfeiture rate in the above scenario may be

acceptable; however, a company should comply with the requirement that the amount of

compensation cost recognized on any date equals at least the compensation cost associated with the

vested portion of the award.

2.7.4 Segregating and analyzing pre-vesting forfeitures

For companies that elect to estimate forfeitures, the forfeiture estimate should generally start with an

analysis of the company’s historical data covering several years. The group of the employee and terms

of an award could affect the likelihood of the award being forfeited; therefore, companies should

evaluate the pre-vesting forfeiture rate of awards by employee group and grouping awards with similar

terms and using a specific forfeiture rate for each group of similar awards. For each grant, actual

forfeitures should be compiled by period (e.g., one year from the grant date, two years from the grant

date, etc.), and the percentage of the remaining outstanding unvested award forfeited each year should

be computed. The company should then average those forfeiture rates to compute an average

historical annual forfeiture rate.

When analyzing forfeitures, companies should segregate forfeitures into two categories: (1) pre-vesting

forfeitures and (2) post-vesting cancellations, as defined earlier. Assume, for example, that a company

grants 500 options and that 100 of the options vest each year, over a five-year requisite service period.

The employee terminates employment after two years. His vested options are underwater, and thus,

are not exercised. Accordingly, the 200 vested options are not pre-vesting forfeitures but, instead,

post-vesting cancellations; the 300 unvested options are pre-vesting forfeitures.

Some software packages used to track stock option activity do not differentiate between pre-vesting

forfeitures and post-vesting cancellations and, therefore, this data in some cases may be difficult to

obtain. Additionally, startups and other companies that do not have a sufficient history to estimate the

expected pre-vesting forfeiture rate might have to rely on surveys of, or disclosures by, other similar

companies. However, ASC 718 does not require disclosure of the forfeiture-rate assumption; therefore,

the ability to obtain public information on forfeiture rates may be limited.

Another factor that may be considered in developing a forfeiture assumption, or in adjusting historical

forfeiture rates, is current human resources or industry near-term forecasts of anticipated employee

turnover by employee group. An annual employee turnover rate and an annual forfeiture rate

assumption may be comparable for this purpose.

Without proper recordkeeping, it will be difficult to accurately compute a historical pre-vesting

forfeiture rate. Making accurate true-up adjustments to recognize actual forfeitures may also be

difficult. Companies should review their recordkeeping systems to assess whether pre-vesting

forfeitures can be separated from post-vesting cancellations; separating the two will ensure that

companies sort the appropriate data to develop an accurate estimate regarding the pre-vesting

forfeitures.


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2.7.5 Examples of the impact of forfeiture policies

Example SC 2-17 illustrates how estimated forfeitures and actual forfeitures interrelate with different

vesting conditions.

EXAMPLE SC 2-17

Accounting for actual and estimated forfeitures for each type of vesting condition

Assumptions for all three scenarios:

SC Corporation grants its employees 5,000 stock options on January 1, 20X1. The grant-date fair value

is $8 per option.

Scenario 1: Service condition

All of the options cliff vest after three years of service. The company has elected a policy to estimate

forfeitures. In 20X1 and 20X2, SC Corporation estimates that 95% of the options will vest. In 20X3, SC

Corporation completes a significant restructuring, which results in only 45% of the options vesting

because 55% of the options are forfeited prior to vesting. Because the actual pre-vesting forfeiture rate

differs dramatically from management’s prior expectations, the company will recognize a credit to

compensation cost in 20X3 as shown below.

20X1 20X2 20X3

Number of options 5,000 5,000 5,000

Fair value per option $8.00 $8.00 $8.00

Fair value of total options $40,000 $40,000 $40,000

Percentage expected to vest 95% 95% 45%

Total expected compensation cost $38,000 $38,000 $18,000

Portion of service period completed at year-end 33% 67% 100%

Cumulative compensation cost recognized at year-end $12,540 $25,460 $18,000

Cumulative compensation cost previously recognized $— $12,540 $25,460

Current-period expense/ (income) (pre-tax) $12,540 $12,920 $(7,460)

Scenario 2: Performance and service condition

The options are subject to a three-year service condition and a performance condition based on each

employee achieving a specific cumulative sales target over the period from 20X1 through 20X3. In

20X1, SC Corporation estimates that 90% of its employees will achieve their targets and remain

employed through 20X3 (i.e., 90% of the options will vest). At the end of year 2, however, SC

Corporation reassesses the likelihood that the targets will be achieved and determines that 95% of the

employees will achieve their targets by the end of 20X2 and remain employed through 20X3. Due to a

new competitor’s product that is launched in 20X3, only 75% of employees actually achieve the

cumulative sales targets.


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20X1 20X2 20X3




Percentage expected to vest 90% 95% 75%





Current-period expense (pre-tax) $11,880 $13,580 $4,540

Scenario 3: Market and service conditions

The options become exercisable only if the employee remains employed by SC Corporation for three

years and SC Corporation’s stock price outperforms the S&P 500 Index by 10% during that three-year

vesting period. The requisite service period is three years because that is the explicit period for the

market condition and the date that the employee must be employed in order to vest in the award. As a

result of the market condition, the fair value of these options is $4.50. Ninety-five percent of the

employees are expected to complete the requisite service period at the end of both 20X1 and 20X2.

At the end of the three-year period, SC Corporation’s stock price has outperformed the S&P 500 Index

by only 3%. Therefore, no awards are exercisable. Additionally, 10% of employees did not complete the

three-year requisite service period as compared to the estimated forfeiture rate of 5%. In this scenario,

the compensation cost should be adjusted to reflect actual forfeitures; however, compensation cost

should not be reversed for the 90% of the employees who fulfilled the requisite service period of three

years, even though the market condition was not met.

20X1 20X2 20X3




Percentage expected to complete requisite service period 95% 95% 90%





Current-period expense (pre-tax) $7,054 $7,267 $5,929


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Scenario 4: Accounting for forfeitures as they occur

Assume the same facts as in Scenario 1, except that the company has elected to account for forfeitures

as they occur. In 20X1, 20X2, and 20X3, actual forfeitures are 0, 750, and 500, respectively.

20X1 20X2 20X3

Number of options not yet forfeited - beginning of year 5,000 5,000 4,250

Number of options forfeited during the year 0 750 500

Number of options not yet forfeited - end of year 5,000 4,250 3,750


Fair value of unforfeited options $40,000 $34,000 $30,000

Portion of service period completed at year end 33% 67% 100%

Cumulative compensation cost recognized at year end $13,200 $22,780 $30,000

Cumulative compensation cost previously recognized 0 13,200 22,780

Current period expense $13,200 $9,580 $7,220

2.7.6 “Last man standing” arrangements

A “last man standing” arrangement is an agreement with more than one employee whereby if the

employment of one of the employees is terminated prior to the end of a defined vesting period, the

stock-based compensation awards granted to that employee will be reallocated among the remaining

employees who continue employment. Because each employee has a service requirement, each

individual grant of stock-based compensation awards should be accounted for separately. Generally,

the accounting for a reallocation under a “last man standing” arrangement is effectively treated as a

forfeiture of an award by one employee and regrant of options to the other employees. Therefore, if

and when an employee terminates his or her employment and options are reallocated to the other

employees, the reallocated options should be treated as a forfeiture of the terminated employee’s

options and a new option grant to the other employees.

2.8 Awards with graded vesting features

Some stock-based compensation awards include graded vesting features such as the award described

in Example SC 2-16. Graded vesting is defined as an award that vests in stages (or tranches). This is in

contrast to cliff vesting, in which an award vests in its entirety on a specific date. In concept, an award


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that vests in tranches can be thought of as a series of individual awards with different cliff-vesting

dates.

Economically, an award with graded vesting is different than a single award with a single cliff-vesting

date for the entire award.

However, for an award with graded vesting that is subject only to a service condition (e.g., time-based

vesting), ASC 718-10-35-8 provides an accounting policy choice between either graded vesting

attribution or straight-line attribution:

□ The graded vesting method: A company recognizes compensation cost over the requisite

service period for each separately-vesting tranche as though each tranche of the award is, in

substance, a separate award. This will result in an accelerated recognition of compensation cost.

□ The straight-line method: A company recognizes compensation cost on a straight-line basis

over the total requisite service period for the entire award (i.e., over the requisite service period of

the last separately-vesting tranche of the award).

A company should apply its policy consistently for all awards with similar features.

Under either attribution method, the amount of compensation cost that is recognized as of any date

should at least equal the grant-date fair value of the vested portion of the award on that date. That is, if

a company elects the straight-line method and the expense recognized to date is less than the grant-

date fair value of the award that are legally vested at that date, the company will need to increase its

recognized expense to at least equal the fair value of the vested amount. This is generally referred to as

the “floor” concept. If a company estimates forfeitures, but actual forfeitures are less than the estimate,

that may also affect the analysis of when the floor will require an increase to the compensation cost

recognized to date.

For awards with graded vesting, a company can either estimate separate fair values for each tranche

based on the expected term of each tranche or estimate fair value using a single expected term

assumption for the entire grant (see SC 9.3). ASC 718-20-55-26 permits a company to choose either

attribution method for awards with only service conditions, regardless of the company’s choice of

valuation technique. If a company estimates separate grant-date fair values for each tranche of the

award, the fair value estimates specific to the tranche should be utilized in determining the minimum

amount of compensation cost to be recognized.

If awards with market or performance conditions include graded vesting features, the graded vesting

method should be used and the straight-line method should not be used. Additionally, if an award

includes both a service condition and a market or performance condition, the graded vesting method

should be used. Companies that grant awards with market or performance conditions and use the

graded vesting method and then modify such awards to remove the market or performance conditions,

should attribute the remaining compensation cost in accordance with its attribution policy for awards

with only service conditions. Therefore, if the company’s attribution policy for awards with only

service conditions is the straight-line approach, following modification of the award, the remaining

compensation cost should be attributed using the straight-line approach.

The application of the graded vesting method of attribution is illustrated in Figure SC 2-9.


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Figure SC 2-9 Award with four tranches that vests 25% each year over four years

Percent of compensation cost recognized each year

Tranche Year 1 Year 2 Year 3 Year 4

1 100% 0% 0% 0%

2 50% 50% 0% 0%

3 33% 33% 34% 0%

4 25% 25% 25% 25%

Entire award 52% 27% 15% 6%

Example SC 2-18, Example SC 2-19, Example SC 2-20, Example SC 2-21 and Example SC 2-22

illustrate the accounting for awards with various vesting conditions as well as graded vesting

provisions.

EXAMPLE SC 2-18

Awards with vesting that accelerates upon a change in control or IPO

SC Corporation grants stock options to employees that vest 25% each year over a four-year period. The

stock options include a provision under which vesting will immediately accelerate upon a change in

control of the company or an IPO. SC Corporation’s accounting policy is to attribute expense using the

straight-line method for awards with graded vesting features and only service conditions.

Can SC Corporation apply the straight-line method of attribution to recognize compensation cost for

the options?

Analysis

Yes. Although the change-in-control or IPO provision is a performance condition, the presence of

which would ordinarily disqualify the use of the straight-line method for graded vesting awards, we

believe this particular type of performance condition does not preclude the use of the straight-line

method. This is because events such as an IPO or change in control are generally considered to be

outside the control of the company and are not considered probable until they occur, as well as the fact

that the IPO is not a vesting contingency (i.e., the award will vest even without an IPO), but rather just

accelerates vesting.

If this award had contained other types of performance conditions that accelerate vesting, such as

achievement of a performance target, the straight-line method could not be utilized.

EXAMPLE SC 2-19

Attribution of expense for an award with “back-loaded” vesting

SC Corporation grants 100,000 stock options to employees that vest based on the following schedule:

□ Year 1 - 10%

□ Year 2 - 20%


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□ Year 3 - 30%

□ Year 4 - 40%

The options are equity classified and vest based only on continued service. The grant-date fair value per option is $10. SC Corporation’s accounting policy is to attribute expense using the straight-line method for awards with graded vesting features and only service conditions.

How much compensation cost should SC Corporation record each year, excluding the impact of

forfeitures?

Analysis

For a four-year service period, the straight-line method results in recognizing 25% of the total

compensation cost, or $250,000 ((100,000 options x $10 fair value) ÷ 4 years), each year, excluding

the impact of forfeitures. Even though only 10% of the awards are legally vested as of the end of Year 1,

it would not be appropriate to recognize only 10% of the compensation cost because SC Corporation’s

accounting policy is to use the straight-line method of attribution. The straight-line method requires

recognizing the total compensation cost evenly over the total vesting period (the requisite service

period of the last separately-vesting tranche of the award).

EXAMPLE SC 2-20

Application of the “floor” concept to a graded vesting award

SC Corporation grants 100,000 stock options to employees that vest 25% each year over a four-year

period based only on continued service. The options are equity classified and have a grant-date fair

value per option of $10 (total compensation cost of $1,000,000). SC Corporation’s accounting policy is

to attribute expense using the straight-line method for awards with graded-vesting features and only

service conditions. SC Corporation elects to estimate forfeitures and therefore, begins recognizing

$970,000 of compensation cost ratably over the four-year service period based on its forfeiture

estimate.

At the end of Year 1, none of the employees have terminated employment; however, SC Corporation

still believes its estimate of total compensation cost for the award, including estimated forfeitures, is

reasonable.

How much compensation cost should SC Corporation record in Year 1?

Analysis

SC Corporation must recognize $250,000 ($1,000,000*25%) of compensation cost in Year 1 because

25% of the awards are legally vested. Applying the straight-line attribution method results in recording

only $242,500 ($970,000*25%) of compensation cost in Year 1 based on SC Corporation’s estimate of

total compensation cost; however, SC Corporation must consider the “floor” concept and record an

additional $7,500 of expense for a total of $250,000 in Year 1.

EXAMPLE SC 2-21

Attribution of expense for an award with “front-loaded” vesting

On July 1, 20X1, calendar year SC Corporation grants restricted stock with a fair value of $300. The

award contains a three year service condition that vest based on the following schedule:


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□ 50% vests after year 1 (June 30, 20X2)



SC Corporation elects the straight-line attribution method as permitted under ASC 718-10-35-8.

ASC 718-10-35-8 requires "the amount of compensation cost recognized at any date must at least equal

the portion of the grant-date fair value of the award that is vested at that date" (i.e., the "floor").

Therefore, SC Corporation must recognize at least $150 of compensation cost at June 30, 20X2 (50%

of the original $300 grant date fair value), rather than $100 which would result from a simple 3-year

straight-line calculation.

For attribution purposes, should the "floor" imposed by ASC 718-10-35-8 be anticipated before the

legal vesting 'trigger' is met?

Analysis

Yes. SC Corporation should anticipate the floor before the legal vesting 'trigger' is met. SC Corporation

should begin to recognize the year 1 expense (contemplating the $150 floor) ratably since the terms of

the arrangement call for 50% to vest during that period. Thus, SC Corporation would begin

recognizing $37.50 ($150/4 quarters) each quarter during the first year of service.

EXAMPLE SC 2-22

Attribution of expense for awards with performance and service conditions

On January 1, 20X1, SC Corporation grants 100,000 stock options to employees that vest based upon

service and achieving an IPO (a performance condition). Under the service condition, 25% of the stock

options vest each year over a four-year period. SC Corporation does not record compensation cost

during 20X1 due to the IPO performance condition. During 20X2, SC Corporation completes an IPO.

After achieving the performance condition, the options continue to vest based only on service

according to the graded vesting schedule.

Can SC Corporation apply the straight-line method of attribution to recognize compensation cost in

20X2 and future years?

Analysis

No. The award contains a performance condition in addition to the time-based graded vesting service

condition; therefore, the straight-line method cannot be used. Although only the service condition

remains after the performance condition is satisfied in 20X2, the use of the straight-line method is not

permitted for this award because the award contains both conditions. SC Corporation should begin

recognizing compensation cost for the options using the graded vesting method once the IPO occurs

with a cumulative catch-up for the service period completed to date.

Note that this example differs from Example SC 2-18 in that both the performance and service

condition are required for vesting. In Example SC 2-18, the change-in-control performance condition

accelerated vesting, but is not a vesting requirement.


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2.9 Accounting for dividends paid on stock-based awards

Some awards stipulate that the employee will receive the dividends paid on the underlying shares

while the option award is outstanding or restricted stock award (or RSU) is unvested. The guidance in

this section applies when employees receive dividends on a recurring basis; for example, when a

dividend is declared annually and the award holders are entitled to the dividend each year. Large, non-

recurring dividends are accounted for as an equity restructuring (refer to SC 4.5). In some

circumstances, judgment may be required to determine whether a dividend payment should be

accounted for as an equity restructuring, as the guidance does not define “large” or “non-recurring.”

2.9.1 Effect of dividends on grant date fair value

If an option award or an RSU is entitled to participate in dividends, that entitlement should be

incorporated in the measurement of the grant date fair value. For an RSU, the grant date fair value

(i.e., the stock price) would already contemplate the expectation of future dividends. However, for an

option that is entitled to participate in dividends, the expected dividend yield assumption would be set

to zero so as not to reduce the value of the option.

2.9.2 Dividends paid on liability-classified awards

All dividends paid on awards classified as liabilities are accounted for as additional compensation cost.

2.9.3 Dividends paid on equity-classified awards

The accounting for dividends paid on awards classified as equity depends on whether the dividends

are forfeitable or nonforfeitable.

2.9.3.1 Nonforfeitable dividends on stock-based awards

Nonforfeitable dividends (i.e., those that recipients may keep once paid, even if they forfeit the

underlying stock award) paid on awards classified as equity are accounted for as follows:

□ For awards that are expected to vest, nonforfeitable dividends paid on equity-classified awards are

recognized as reductions in retained earnings.

□ For awards that are not expected to vest or do not ultimately vest, nonforfeitable dividends paid

are accounted for as additional compensation cost.

For companies that elect to estimate forfeitures, the accounting treatment of nonforfeitable dividends

paid on equity-classified awards should be based on the company’s estimate of the awards expected to

vest. The estimate of the awards expected to vest should be adjusted when the forfeiture rate

assumption is adjusted and trued up for actual forfeitures. For example, a reclassification from

retained earnings to compensation cost would be necessary to account for dividends paid on awards

originally expected to vest that are ultimately forfeited.

Companies that elect to account for forfeitures when they occur should initially record all dividends

paid on equity-classified awards to retained earnings and then reclassify the amount of non-forfeitable

dividends previously charged to retained earnings relating to awards that are forfeited to

compensation cost in the period the forfeitures occur.


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2.9.3.2 Forfeitable dividends on stock-based awards

Dividends paid on equity-classified awards are often subject to the same vesting conditions as the

underlying awards. An example is a dividend on an unvested restricted stock award that is not paid to

the employee until the restricted stock vests. Such dividends are forfeited if the award is forfeited.

These dividends are forfeitable (as opposed to nonforfeitable) and therefore, would not result in the

recognition of additional compensation cost as long as the award is equity-classified.

When the dividend is declared, companies that elect to account for forfeitures when they occur should

recognize a debit to retained earnings and a credit to dividend payable for all awards (see FG 4.4.2). If

an award (and the associated dividend) is ultimately forfeited, that entry is reversed with a debit to

dividends payable and a credit to retained earnings. The reversal entry would be made in the period in

which the forfeitures occur.

Companies that elect to estimate forfeitures should record the dividend payable and corresponding

charge to retained earnings based on the company’s estimate of the awards expected to vest. This

estimate should be adjusted when the forfeiture rate assumption is adjusted and trued up for actual

forfeitures.

2.9.4 EPS considerations for stock awards with dividend rights

Unvested awards that contain nonforfeitable rights to dividends are considered participating securities

for purposes of computing earnings per share. Refer to FSP 7.4.2.5 for further discussion.

2.10 Capitalized compensation cost

When describing stock-based compensation, ASC 718 uses the term “compensation cost” rather than

“compensation expense” to emphasize that stock-based compensation may be capitalized similar to

the treatment of cash compensation or other employee benefit costs. When it is appropriate for an

entity to capitalize the cost of employee benefits paid in cash, stock-based compensation paid to those

employees should generally be treated in a similar manner. For example, employee costs may require

capitalization as part of the cost of:

□ Inventory

□ Deferred loan origination costs

□ Costs to fulfil a contract

□ Self-constructed fixed assets

□ Capitalized internal-use software

□ Capitalized software costs

Once capitalized, compensation cost becomes part of the cost of the respective asset and subject to the

requirements of the applicable GAAP that required its capitalization. When determining the amount of

compensation cost to capitalize, companies should consider the effects of pre-vesting forfeitures and

the potential reversal of capitalized compensation cost if the pre-vesting forfeiture rate assumption is

trued-up (or upon actual forfeitures for those that elect to account for forfeitures when they occur).


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ASC 718 does not provide specific guidance regarding compensation cost that qualifies for

capitalization under other GAAP. SAB Topic 14 includes an interpretation on the capitalization of

compensation cost as part of inventory. The SEC staff believes that a company may record a period-

end adjustment to reflect the changes for capitalized compensation cost instead of recording the

changes through the inventory-costing system. A company would need to establish appropriate

controls surrounding the calculation and recording of this period-end adjustment, similar to any other

period-end adjustment.

ASC 718 provides limited guidance on the income tax effects related to capitalized compensation cost.

See TX 17.15 for more guidance on the income tax effects of capitalized compensation cost.

2.11 Illustrations

Example SC 2-23 further illustrates the concepts discussed in this chapter.

EXAMPLE SC 2-23

Accounting for the award using graded vesting and straight-line attribution

For simplicity, the following assumptions have been made:

□ Only annual periods are illustrated; quarterly information is not presented

□ None of the compensation cost is subject to capitalization under other GAAP

□ Income tax considerations are ignored. Refer to TX 17 for guidance on the income tax implications

of stock-based compensation awards

Facts and background

□ SC Corporation is a US public company with a calendar year end

□ All of the awards granted in the following examples are equity classified

□ SC Corporation’s common stock has a par value of $0.01 per share

□ The award is granted on January 1, 20X0 and has only a service condition

□ SC Corporation has elected to estimate forfeitures and the pre-vesting annual forfeiture

assumption on the grant date is 5%


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Number of options granted 100,000

Grant date Jan. 2, 20X0

Stock price on grant date $100

Exercise price $100

Vesting 1/3 each year for 3 years

Contractual term 10 years

Expected term 6 years

Expected volatility of the underlying common stock 30%

Expected dividend yield on stock 0%

Risk-free interest rate (continuously compounded) 3%

Estimated fair value per option under the Black-Scholes model $35.29

Upon termination of employment, unvested options are forfeited and the contractual term of vested

options truncates to 90 days from the termination date.

Scenario 1

On January 1, 20X0, SC Corporation grants 100,000 options with an exercise price of $100. Options

vest evenly over three years. The grant-date fair value is $35.29 per option. Employees are given 90

days to exercise options in the event of termination.

Under the graded vesting attribution approach, each annual vesting tranche has a different requisite

service period over which employees earn the awards. At the end of 20X0, employees will have vested

in 100% of Tranche 1, will have completed 50% of the requisite service period for Tranche 2 and will

have completed 33% of the requisite service period for Tranche 3. SC Corporation applies an annual

forfeiture rate assumption of 5% to each tranche, which means that, at the grant date, SC Corporation

expects that 95% of Tranche 1, 90.25% (.95 × .95) of Tranche 2, and 85.74% (.95 × .95 × .95) of

Tranche 3 will vest.

The following tables present the number of options expected to vest and the related compensation cost

estimated from the grant date through the end of the requisite service period.

Proportion of grant date fair value recognized as

compensation cost

Tranche Number of options expected to vest 20X0 20X1 20X2

1 31,667 95%

2 30,083 45% 45%

3 28,579 28.6% 28.6% 28.6%

Totals 90,329 62.3% 27.2% 10.5%


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Compensation cost recognized each year

Tranche Number of options expected to vest 20X0 20X1 20X2

1 31,667 $1,117,528

2 30,083 530,815 $530,815

3 28,579 336,184 336,184 $336,184

Totals 90,329 $1,984,527 $866,999 $336,184

The following schedule summarizes option activity through 12/31/20X4, showing the number of

options each year that legally vested and the number of options exercised and cancelled.

Date Vested Exercised Post-vesting cancellations

12/31/20X0 31,667 − −

12/31/20X1 30,083 − −

12/31/20X2 28,579 − −

12/31/20X3 − − (6,000)

12/31/20X4 − (50,000) −

Totals 90,329 (50,000) (6,000)

Note that from 20X0 to 20X2, actual forfeitures were 5% annually, which was exactly as expected. As a

result, SC Corporation did not have to adjust its expected compensation cost.

How should SC Corporation account for the awards using graded vesting attribution?

Analysis

Based on the above activity, SC Corporation would record the following journal entries.

Dr. Compensation expense $1,984,527

Cr. Additional paid-in capital $1,984,527

To recognize 20X0 compensation expense



To recognize compensation expense in 20X1


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On October 1, 20X3, employees with collectively 6,000 options terminated their employment. The

options remain underwater through December 31, 20X3 and are then cancelled in accordance with the

term truncation. Previous compensation expense is not reversed because the terminated employees

completed the three-year service condition.

On December 31, 20X4, employees exercised 50,000 options when the market price of SC

Corporation’s common stock was $140 per share.

SC Corporation would record the following journal entry.

Dr. Cash $5,000,000

Cr. Common stock $500


To recognize the exercise of 50,000 options at an exercise price of $100

Scenario 2

Assume the same facts as Scenario 1 except that in Scenario 2 SC Corporation uses straight-line

attribution.

The following table presents the number of options expected to vest and the related compensation

cost.

Total 20X0 20X1 20X2

Number of options expected to vest

90,329 31,667 30,083 28,579

Compensation cost $3,187,710 $1,117,528 $1,061,629 $1,008,553

How should SC Corporation account for the awards using straight-line attribution?

Analysis

The annual forfeiture-rate assumption is applied to each tranche to determine the total number of

awards expected to vest and, therefore, the total compensation cost. As SC Corporation elected the

straight-line attribution method, the total compensation cost is recognized on a straight-line basis over

the requisite service period for the entire award (i.e., over 3 years—the requisite service period of the

last separately vesting portion of the award). However, ASC 718-10-35-38 requires that the amount of

compensation cost recognized at any date must at least equal the portion of the grant-date value of the

award that is vested (i.e., the “floor”). Therefore, in the first year, the minimum amount of cost that

must be recognized in this fact pattern is the amount that legally vests. Assuming the forfeiture


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estimate was accurate, then 95% of the cost of the first tranche of awards must be recognized, or

$1,117,528. The estimate of expected forfeitures would need to be updated each period based on actual

experience. Other approaches for determining and applying the forfeiture rate to the attribution

approach in this scenario may be acceptable.

SC Corporation would record the following journal entries.










Dr. Cash $5,000,000



To recognize the exercise of 50,000 options at an exercise price of $100 on December 31, 20X4

Chapter 3: Liability-classified awards

Liability-classified awards

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3.1 Liability-classified awards chapter overview

This section addresses the recognition and measurement principles and the criteria for determining

whether an award is a liability. In particular, it discusses the accounting for (1) awards with conditions

or features indexed to something other than a market, performance, or service condition, (2)

obligations based on a fixed monetary amount, and (3) awards with repurchase features. This section

also provides flowcharts summarizing the criteria for determining liability or equity classification.

3.2 Recognition and measurement principles for liability awards

The basic measurement principle for liability-classified awards is fair value, the same as it is for

equity-classified awards. As discussed in SC 6.2.2, a nonpublic company may make an accounting

policy election to use intrinsic value to measure its liability-classified awards. However, a liability-

classified award differs from an equity-classified award, which is generally measured at fair value on

the grant date, in that it is remeasured to an updated fair value at each reporting period until the

award is settled. For a liability-classified award, a company would do the following:

□ Measure the fair value of the award on the grant date.

□ Recognize compensation cost over the requisite service period.

□ Remeasure the fair value of the award each reporting period until the award is settled.

□ True up compensation cost each reporting period for changes in fair value pro-rated for the

portion of the requisite service period rendered.

□ Once vested (i.e., the requisite-service period is complete), immediately recognize compensation

cost for any changes in fair value until settlement.

As discussed in SC 8.2, the fair value of a share-based payment is measured using an option pricing

model and includes both the intrinsic value and time value of the award. As employees vest in liability-

classified awards and the remaining time until settlement or expected settlement of the award

decreases, the time value of these awards will decrease and approach zero until, on the settlement

date, the awards’ fair value will equal intrinsic value.

Example SC 3-1 illustrates the accounting for liability-classified awards.

EXAMPLE SC 3-1

Initial measurement and subsequent measurement of a liability award

On January 1, 20X1, SC Corporation grants 100 of its employees 100 cash-settled stock appreciation

rights (SARs) for a total of 10,000 SARs. Each SAR entitles the employee to receive cash equal to the

increase in value of the underlying stock over $20 (the current stock price). The SARs will cliff-vest

when the employees complete three years of service. SC Corporation determines that, based on the

awards’ service condition, the requisite service period is three years.


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Using an option-pricing model, SC Corporation determines that the grant-date fair value of each SAR

is $5. Because the awards were granted with no intrinsic value (i.e., “at the money”), the SAR’s fair

value of $5 consists entirely of time value. The SARs’ aggregate fair value is $50,000 on January 1,

20X1, the grant date.

On December 31, 20X1, the end of the first year of the requisite service period, SC Corporation

determines that the SAR’s fair value is $6 per SAR ($60,000 in total).

For simplicity, consideration of forfeitures has been excluded.

How much compensation cost should SC Corporation record in the first year related to the SARs?

Analysis

Because the employees completed one-third of the requisite service period by December 31, 20X1, SC

Corporation would recognize $20,000 (10,000 SARs × $6 fair value of each SAR × 1/3 portion vested)

of compensation cost.

At the end of each subsequent reporting period over the next two years, SC Corporation will continue

to remeasure the current fair value of the award and adjust cumulative compensation expense to the

appropriate portion of the total fair value in relation to the portion of the requisite service period that

has been completed.

For reporting periods after the requisite service period is completed, SC Corporation would continue

to remeasure the SAR’s fair value, recognizing the entire change in fair value (positive or negative)

immediately in the income statement because the SAR is fully vested. That remeasurement process

continues until settlement.

On the settlement date, SC Corporation would remeasure the SARs’ fair value (which should be equal

to the intrinsic value) and recognize the change in fair value as an adjustment to compensation cost.

3.2.1 Awards with performance and market conditions

Accounting for vesting conditions of liability-classified awards follows the same principles as equity-

classified awards (discussed in SC 2). Assuming all conditions for a grant date have been met, a

company should begin recognizing compensation cost for liability-classified awards with performance

conditions when it becomes probable that the performance condition will be met. The measurement of

compensation cost, however, would be based on the fair value of the award at each reporting date (i.e.,

remeasured each period) and the portion of the requisite service period completed.

For liability-classified awards with a market condition, the same periodic remeasurement approach

applies, with the impact of the market condition incorporated into the determination of fair value each

period. However, if the market condition is not satisfied, the fair value on the settlement date will be

zero; therefore, on a cumulative basis, the company would recognize no compensation cost. This is in

contrast to an equity-classified award with a market condition, for which the minimum amount of

compensation cost to be recognized is the grant-date fair value even if the market condition is not

satisfied (subject to satisfaction of the requisite service period).


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3.3 Criteria for determining whether an award is a liability

The criteria for determining whether an award should be classified as a liability or as equity are

outlined in ASC 718-10-25-6 through ASC 718-10-25-18. The following are the types of awards that

companies should classify as liabilities:

□ An award with conditions or other features that are indexed to something other than a market,

performance, or service condition.

□ An award that meets certain criteria of ASC 480, Distinguishing liabilities from equity.

□ A share award with a repurchase feature that permits an employee to avoid bearing the risks and

rewards normally associated with equity ownership for a reasonable period of time by allowing the

employee to put shares to the company within six months after the employee vests in the shares

or

A share award where it is probable that the employer would prevent the employee from bearing

the risks and rewards normally associated with stock ownership within six months after share

issuance.

□ An option or similar instrument that could require the employer to pay an employee cash or other

assets, unless cash settlement is based on a contingent event that is (a) not probable and (b)

outside the control of the employee.

□ An option or similar instrument in which the underlying shares are classified as liabilities.

3.3.1 Other than market, performance, or service condition awards

In some cases, an award’s vesting or exercisability may be indexed to a factor that is in addition to the

company’s stock price (e.g., dual-indexed awards). If the factor is not a market, performance, or

service condition, the award should be accounted for as a liability, in essence a derivative. Also, an

award would be dual-indexed if it contains a performance condition that is measured against a

different measure of performance of another entity or group of entities. A condition other than a

market, performance, or service condition should be reflected in estimating the fair value of the award.

The following are examples of awards that are indexed to something other than a market,

performance, or service condition:

□ A stock option with an exercise price that is indexed to the market price of a commodity (e.g.,

platinum, soybeans, live cattle).

□ An award that vests based on the appreciation in the price of a commodity (e.g., natural gas) and

the company’s shares and is thus indexed to both the value of that commodity and the company’s

shares.

□ A stock option with an exercise price that is indexed to the Consumer Price Index, some other

measure of inflation, or another external index.


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□ An award that vests based on the company’s EBITDA growth exceeding the average growth in net

income of peer companies over the next three years.

□ An award that vests based on the company achieving a specified level of growth in revenue in

excess of the increase in inflation (i.e., “real” growth).

Note that in the first two examples above, the award would be liability-classified even if the entity

granting the share-based payment award is a producer or user of the commodity whose price changes

affect the entity’s results of operations and overall entity value. In other words, there is no exception to

the liability-classification guidance for an index that is “clearly and closely related” to the entity’s

operations.

3.3.2 Certain criteria in ASC 480 applicable to stock awards

ASC 480 provides guidance for determining whether certain freestanding financial instruments are

classified as liabilities and generally excludes stock-based compensation from its scope. However, ASC

718 requires companies to apply the classification criteria in ASC 480-10-25 and paragraphs ASC 480-

10-15-3 through ASC 480-10-15-4 when determining whether stock-based compensation awards

should be classified as a liability unless ASC 718-10-25-6 through ASC 718-10-25-18 require otherwise.

3.3.2.1 Overview of ASC 480 and related stock award examples

ASC 480 specifies that financial instruments within its scope embody obligations of the issuer and

should be classified as liabilities. Figure SC 3-1 summarizes three types of freestanding financial

instruments that companies should classify as liabilities by reference to ASC 480-10-25 and

paragraphs ASC 480-10-15-3 through ASC 480-10-15-4.

Figure SC 3-1 Examples of freestanding financial instruments classified as liabilities

Instruments classified as liabilities Examples

Mandatorily redeemable financial instruments

ASC 480 defines “mandatorily redeemable” as an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur

□ Preferred stock that must be redeemed on a

specified date

□ Common stock that must be redeemed upon

the employee’s death or termination of

employment (unless the instrument is issued

by a nonpublic non-SEC registrant and is

excluded from the scope of ASC 480)

Obligations to repurchase a company’s equity shares by transferring assets

□ A written put option on the company’s equity

shares that requires physical or net-cash

settlement

□ A forward purchase contract for the company’s

equity shares that requires cash settlement

□ Compound instruments, other than

outstanding shares, such as a collar that

includes a written put option


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Instruments classified as liabilities Examples

Certain obligations to issue a variable number of the company’s shares

A financial instrument that meets both of the following conditions: (1) the company must or could settle the obligation by issuing a variable number of its shares, and

(2) the obligation’s monetary value is based solely or predominantly on any of the following factors at the obligation’s inception:

□ A fixed monetary amount that is known at the obligation’s inception (e.g., a fixed dollar amount settled in a variable number of shares)

□ Variations in something other than the fair value of the company’s shares (e.g., the price of silver or corn or the free cash flow of the company)

□ Variations in the fair value of the company’s equity shares, but moves in the opposite direction

□ An arrangement under which the company

will settle a bonus that is a fixed dollar amount

by issuing a variable number of shares based

on the stock price at the time of settlement

3.3.2.2 ASC 480 scope exceptions on stock awards

The FASB excluded from the scope of ASC 480 nonpublic, non-SEC registrants’ financial instruments

that will be mandatorily redeemable upon the occurrence of an event that is certain to take place (e.g.,

the death or termination of service of the holder). For additional guidance, refer to SC 6.3, which

discusses how this scope exception specifically impacts nonpublic companies.

3.3.2.3 Obligations based on a fixed monetary amount

As noted in Figure SC 3-1 one of the types of instruments subject to liability accounting under ASC 718

(by reference to ASC 480) is an obligation that is based solely or predominantly on a fixed monetary

amount that is known at the obligation’s inception. A straightforward example of this type of

instrument is a bonus based on a fixed dollar amount that will be settled by issuing shares on the

vesting date, with the number of shares to be determined based on the company’s stock price on the

settlement date. In this example, the company would generally record compensation cost for the fixed

dollar amount of the award over the vesting period, with a corresponding liability. Note that while

recognition and measurement of compensation cost for these awards are subject to the general grant

date criteria described in SC 2.6.1, the criterion that the employee must begin to benefit from, or be

adversely affected by, subsequent changes in the employer’s stock price does not apply to this type of

award. This is because the award is based on a fixed monetary amount; its value will never be affected

by changes in the stock price.

More complex instruments will need to be carefully analyzed to determine whether the obligation is

based predominantly on a fixed monetary amount. For example, a company grants an equity-settled

award that vests based on a market condition; however, the company also establishes a dollar-value

cap on the award that may limit the number of shares to be issued upon settlement. As a result, in

certain outcomes, the value of the award on the settlement date will vary based on the company’s stock

price (i.e., if the value of the equity is less than the cap), while in other outcomes, the value of the


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award will be based on a fixed dollar amount (i.e., if the value of the equity exceeds the dollar-value

cap). In this scenario, the company should assess whether the dollar-value cap is a predominant

feature of the award. To accomplish this, one approach is to use a lattice model to determine the

percentage of possible outcomes that would result in the award being settled in the amount of the

dollar cap. If the company concludes that the dollar cap feature is predominant, the award should be

classified as a liability. See FG 5.5.1.1 for further discussion on the meaning of “predominant.”

Example SC 3-2 and Example SC 3-3 illustrate awards that have a range of potential payouts, and the

impact on the classification of the award.

EXAMPLE SC 3-2

Awards with a range of potential payouts based on increase in EBITDA

SC Corporation grants its CEO an award of restricted stock on January 1, 20X1. The ultimate dollar

value of the award depends on the percentage increase in SC Corporation’s EBITDA during 20X1. SC

Corporation will issue the following value of common stock on December 31, 20X1 based on the

specified increases in its EBITDA during 20X1.

Increase in EBITDA Dollar amount of award

greater than 20% $1.0 million

between 15% and 20% $0.8 million



less than 5% $0

The award will be settled only in shares of SC Corporation common stock valued based on the stock

price on December 31, 20X1 (the date the shares will be issued). In other words, the dollar amount of

the award will be divided by the stock price on December 31, 20X1 to yield the number of shares that

will be issued to the CEO.

How should SC Corporation account for the performance award to the CEO?

Analysis

The award should be accounted for as a liability award with a performance condition. An award based

on a fixed dollar amount is a liability in accordance with ASC 480-10-25-14. Liability classification is

also appropriate for an award that has several possible fixed dollar amount settlements that are not

solely or predominantly based on the value of the company’s shares. In this case, the monetary value of

the award fluctuates based on changes in EBITDA, not stock price. The award will be settled with a

variable number of shares based on the then-current stock price, and therefore is a liability award.

Expense would not be recognized until achievement of one of the performance targets is deemed

probable. The expense to be recognized would be based on SC Corporation’s best estimate of the

ultimate outcome at the end of each reporting period. Once the number of shares has been fixed (in

this case when the shares are issued), the award would be reclassified to equity.


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EXAMPLE SC 3-3

Awards with a range of potential payouts based on increases in stock price

SC Corporation grants its CEO an award of common stock on January 1, 20X1. The value of the award

depends on the percentage increase in SC Corporation’s stock price during 20X1. SC Corporation will

issue the following amount of common stock on December 31, 20X1 based on the specified increases in

its common stock price during 20X1.

Increase in stock price Dollar amount of award

greater than 20% $4 million


between 10% and 15% $3 million


less than 5% $0

The award will be settled only in shares of SC Corporation common stock valued based on the stock

price on December 31, 20X1 (the date the shares are issued). In other words, the dollar amount of the

award will be divided by the stock price on December 31, 20X1 to yield the number of shares that will

be issued to the CEO.

How should SC Corporation account for the award to the CEO?

Analysis

The award should be accounted for as an equity award with a market condition. An award based on a

fixed dollar amount (or a dollar amount predominantly based on changes other than in the company’s

stock price) is a liability; however, given the number of potential outcomes within the range, which

increase directionally with the value of the stock, the award given to the CEO is more akin to a stock-

settled SAR than to stock-settled debt (described in ASC 480-10-25-14(a)).

When evaluating if an award is akin to a stock-settled SAR, a company should consider the range of

potential settlement values, not just the number of scenarios. The potential outcomes should not be so

close together that, in substance, there is only one outcome. Also, the outcomes should not be so far

apart that all but one of the outcomes are non-substantive.

3.3.3 Shares with repurchase features

A repurchase feature gives the employee the ability to put (redeem) the shares to the company for cash

or gives the company the ability to call (repurchase) the shares for cash. Under ASC 718, companies

should evaluate the terms of their share awards that contain repurchase features in order to determine

whether liability classification of an award is required, as described below.


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A company should classify a share that is puttable by the employee or callable by the employer as a

liability if either of the following conditions is met:

□ The employee can avoid bearing the risks and rewards normally associated with equity ownership

(as a result of the repurchase feature), for a reasonable period after the share’s issuance.

□ It is probable that the employer will prevent the employee from bearing the risks and rewards

normally associated with equity ownership for a reasonable period after the share’s issuance.

An employee begins to bear the risks and rewards of stock ownership when, for example, an employee

receives shares upon exercise of an option or vests in a restricted stock award. ASC 718 defines a

reasonable period as a minimum of six months.

An employee put right would allow the employee to avoid bearing the risks and rewards of stock

ownership for a reasonable period if the employee can put shares to the company (1) at fair value

within six months after the employee vests in the shares (or exercises a vested option) or (2) either

before or after six months, at a fixed redemption amount or another amount that is not based on

variations in the company’s stock price. The probability of the employee exercising the put right is not

a relevant factor. If the repurchase price is an amount other than fair value (e.g., derived using a

formula), the share-based arrangement should generally be classified as a liability because the price is

not based on variations in the company’s stock price, and, therefore, the employee is not bearing the

risks and rewards of stock ownership (regardless of how long the employee holds the shares). There is

a limited exception for certain nonpublic company plans that qualify as book value plans. Refer to SC

6.4 for a discussion of book value plans. If a repurchase feature gives the employee the right to put

shares back to the company after six months for the fair value of the shares at the date of repurchase

plus a fixed amount, the repurchase feature would not cause the award to be classified as a liability;

however, ASC 718-10-55-85 provides that the fixed amount over the fair value should be recognized as

additional compensation cost over the requisite service period with a corresponding liability.

An employer call right may require liability classification of an award if it is probable that the employer

will exercise the call right (1) within six months of the issuance of a vested share (or exercise of a

vested option) or (2) either before or after six months at a fixed redemption amount or another

amount that is not based on variations in the company’s stock price. When assessing whether it is

probable that an employer will prevent the employee from bearing the risks and rewards of stock

ownership, we believe the following factors should be considered:

□ How the repurchase price will be calculated.

□ Management’s stated representation regarding its intent to call the shares.

□ The frequency with which the employer has called shares in the past.

□ The circumstances under which the employer has called shares in the past.

□ The existence of any legal, regulatory, or contractual limitations on the employer’s ability to

repurchase shares.

□ Whether the employer is a closely held, private company with a policy that shares cannot be widely

held, which would indicate an increased likelihood that the employer will repurchase the shares.


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If a share award is classified as a liability because of a repurchase feature and either (a) the put or call

feature expires unexercised or (b) at least six months have passed since the employee began bearing

the risks and rewards of stock ownership, the award should be reclassified as equity (assuming it

meets all other requirements for equity classification). A change in classification to an equity award

should be accounted for as a modification (see guidance in SC 4.4).

If a share award with repurchase features is classified as equity, SEC registrants should also consider

whether classification of the award as temporary equity is appropriate. See SC 3.3.10 for further

guidance.

Example SC 3-4 illustrates the accounting for an award that has an in-substance put option exercisable

by the employee immediately upon vesting.

EXAMPLE SC 3-4

Classification of an award that may be deferred upon vesting and placed in a rabbi trust

SC Corporation grants an employee nonvested stock that vests in three years. Upon vesting, the

employee may choose to take delivery of the stock, or defer receipt of the stock and have the shares

placed in a rabbi trust.

The terms of the rabbi trust permit the employee to immediately diversify by exchanging the shares

into investments in nonemployer securities held by the rabbi trust. In that circumstance, the

arrangement will ultimately be settled in the future in cash in relation to the value of the diversified

investments.

Prior to vesting and deferral in the rabbi trust, should the nonvested stock award be classified as a

liability under ASC 718?

Analysis

Yes. Because the employee has the ability, immediately upon vesting, to elect to diversify the stock into

nonemployer securities, which will ultimately be settled in cash, we believe the stock compensation

arrangement should be classified as a liability. While this fact pattern is not technically an employee

put feature, we believe the substance is the same, in that it allows the employee to elect cash

settlement from SC Corporation without bearing the risks and rewards of share ownership for six

months from the vesting date.

Conversely, if the employee must hold the employer stock within the rabbi trust for six months prior to

diversifying, the employee is subject to risk and rewards of share ownership for a reasonable period of

time after the share is issued. In that fact pattern, the nonvested stock award would not be classified as

a liability prior to its deferral in the rabbi trust. However, public companies would recognize the award

in temporary equity, following the guidance in ASC 480-10-S99-3A.

3.3.3.1 Share repurchase upon occurrence of a contingent event

ASC 718 also provides guidance regarding shares with repurchase features that can be exercised only if

a contingent event occurs. Under ASC 718-10-25-9, an award with a repurchase feature that can only

be exercised upon a contingent event that is (1) not probable and (2) outside the control of the

employee would be equity classified. The probability of the contingent event occurring should be

http://www.pwccomperio.com/contents/english/external/us/gaap/718/topic_718.htm

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reassessed each reporting period. For example, a put feature that an employee can exercise upon an

initial public offering would not require liability accounting until and unless it becomes probable that

the initial public offering will occur prior to the employee bearing the risk and rewards of stock

ownership for at least six months. Because an initial public offering is not probable until it occurs (i.e.,

until the offering closes), liability accounting would begin on the date of the initial public offering.

It is common for employer call rights to exist that are exercisable only upon termination of an

employee’s employment (for any reason). Although the employee may have the ability to voluntarily

terminate (and thus control the contingent event), in the case of an employer call right, the company

should consider the probability of whether the call is expected to be exercised prior to the employee

bearing the risks and rewards of ownership for a reasonable period of time (six months).

Example SC 3-5 illustrates the determination of the classification for an award that has a call feature

exercisable upon employee termination.

EXAMPLE SC 3-5

Classification of an award with a call feature upon employee termination

SC Corporation grants a nonvested stock award to an employee with a two year vesting period. The

award contains a call feature that permits the company to repurchase any vested shares at fair value in

the event the employee terminates employment. The company has stated it would likely exercise the

call in the event the employee terminates, even if termination is within six months of vesting (though

the company would make this ultimate assessment if and when the termination occurs). The company

does not currently believe it is probable the employee will terminate while holding immature shares,

and likewise does not believe it is probable the call will be exercised before the employee has borne the

risks and rewards of equity ownership for at least six months.

Should SC Corporation classify this award as a liability?

Analysis

While it is probable that the employee will ultimately terminate employment at some point, and the

company has acknowledged its likely intent to exercise the call if the employee were to terminate, since

it is not currently probable that the employee will terminate (and the call right exercised) within 6

months of vesting, it is acceptable to classify the award as an equity instrument. In the event it

becomes probable that the employee will terminate and the company will exercise the call within six

months of vesting, the award would be reclassified as a liability, following the guidance for equity-to-

liability modifications in ASC 718-20-55-144 (refer to SC 4.4.1). Note that this analysis may be

different if the repurchase price was based on a formula that did not result in the holder bearing the

risks and rewards of equity ownership, as the six-month holding period may not apply in that case.

3.3.4 Options settled in cash or other assets

An option or similar instrument that is required to be settled in cash or other assets is classified as a

liability. For example, the awards in Example SC 3-1 (cash-settled SARs) are classified as liabilities

because the awards will be settled in cash. A stock-settled SAR would be classified as equity (assuming

the award meets all other requirements for equity classification). Similarly, a feature that allows an

option to be net-share settled (i.e., shares are issued equal to the difference in value between the fair


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value of the shares and exercise price of the option on the exercise date) does not on its own cause the

option to be classified as a liability.

If a company grants an award that offers a choice of settlement in stock or in cash (sometimes referred

to as a tandem award), the classification of the award depends on whether the employee or the

company has the choice of the form of settlement. If the employee can choose the form of settlement

and can potentially require the company to settle the award in cash, the award should be classified as a

liability. If the company has the choice of settlement, it can avoid transferring assets by electing to

issue stock. In that case, as long as the company has the ability to deliver shares (i.e., sufficient

authorized shares) the award would be classified as equity. ASC 718-10-25-15(a) clarifies that when

assessing the company’s ability to deliver shares, a requirement to deliver registered shares should

not, on its own, result in liability classification of the award.

The written terms of a stock-based compensation award are generally the best evidence to indicate

that the award is a liability. However, a company’s past practice of settlement may outweigh the

written terms, resulting in a conclusion that an award that in form appears to be equity is, in substance

a liability. For example, if a company’s past practice has been to settle options in cash or it settles in

cash whenever an employee asks for cash settlement, this would likely indicate that the options are in

substance liabilities, even when the company retains the choice of settling the option in shares.

Additionally, when considering the company’s ability to settle in shares, the company should consider

the amount of shares currently authorized and available for issuance in its stock option plan. The

number of shares that the company needs to have available for issuance may depend on whether it has

the ability to settle stock options on a net basis (i.e., net of the exercise price). If the company does not

have sufficient shares authorized and available for issuance to settle its outstanding awards, the

amount that the company could not settle in shares should be accounted for as a liability.

Example SC 3-6 and Example SC 3-7 illustrate the considerations in evaluating a company’s ability to

deliver shares.

EXAMPLE SC 3-6

Grant of more than the current number of authorized shares

SC Corporation currently has one million shares authorized and unissued for its stock option plan. If

additional authorized shares were needed to settle stock compensation awards, shareholder approval

would be required.

SC Corporation granted two million at-the-money stock options on January 1, 20X1, which under the

terms of the option plan, may be settled in any of the following ways at SC Corporation’s election:

□ Gross settlement—by physical delivery of two million shares in exchange for the aggregate exercise

price

□ Net-share settlement— delivery of shares with a value equal to the difference between the market

price at the date of exercise and the exercise price

□ Net-cash settlement— delivery of cash equal to the difference between the market price at the date

of exercise and the exercise price


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As SC Corporation does not have a sufficient number of authorized shares to satisfy the gross

settlement alternative, should some or all of the award be classified as a liability?

Analysis

Not necessarily. The analysis will depend on SC Corporation's intent. In this scenario, although SC

Corporation may not currently have the ability to deliver shares to satisfy gross settlement of all of the

options, the terms of the plan permit net share settlement at SC Corporation's election. Thus, we

believe it would be appropriate to determine whether SC Corporation intends to settle the awards net

and if sufficient shares are authorized to satisfy net settlement.

If at some point the number of shares needed to net share settle the award exceeds the total shares

authorized, the incremental portion would be accounted for as a liability, as the only other alternative

is to cash settle the award. In that circumstance, equity to liability modification accounting should be

applied; refer to SC 4.4.1.

EXAMPLE SC 3-7

Grant of awards subject to shareholder approval

SC Corporation grants awards to employees. In order for SC Corporation to settle the awards in equity,

SC Corporation's shareholders must annually approve the release of the appropriate number of shares

to satisfy the equity settlement. Although this generally occurs on or near the vesting date of the

awards, management and the Board do not control enough votes to ensure this outcome. In the

absence of shareholder approval, SC Corporation would be obligated to deliver cash to settle the

awards.

On the grant date, does SC Corporation have the ability to deliver shares to support equity

classification?

Analysis

No. In this fact pattern, SC Corporation’s ability to deliver shares to satisfy the equity settlement is

contingent upon shareholder approval; accordingly, SC Corporation would not be able to support

equity classification on the grant date. Therefore, on the grant date, SC Corporation would classify the

awards as liabilities until such time as they have the ability to deliver shares (in this case, upon

shareholder approval).

3.3.4.1 Options with contingent cash settlement features

A stock option or award that has a cash settlement feature only upon the occurrence of a contingent

event does not result in liability classification under ASC 718-10-25-11 if the contingent event is (1) not

probable and (2) outside the control of the employee. For example, if an employee could force the

company to settle stock options in cash upon a change in control, this feature would not result in

liability accounting until the change in control event becomes probable. Generally, a change in control

event is not considered probable until it occurs.

The probability of the contingent event occurring should be reassessed each reporting period. If the

contingent event becomes probable, the stock option should be classified as a liability, and the change


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in classification should be accounted for as a modification from an equity award to a liability award

(see guidance in SC 4.4).

SEC registrants should also consider whether the classification of awards with contingent cash

settlement features as temporary equity is appropriate. See SC 3.3.10 for further guidance.

3.3.4.2 Awards settled partially in cash and partially in equity

Certain awards may be structured such that a portion of the award will be settled in equity and a

portion will be settled in cash. Generally, it is appropriate to account for each part of the award

separately.

An example of an award that is settled partially in cash and partially in equity is an option that

includes a cash bonus feature designed to reimburse the employee for a portion of his or her personal

income tax liability related to the exercise of the options. In this particular fact pattern, it would

generally be appropriate to account for the option and the cash bonus as separate awards. The option

would be equity-classified, assuming all other requirements for equity classification are met. The cash

bonus is within the scope of ASC 718 because the amount of the bonus is based on changes in the

company’s stock price; therefore, the cash bonus should be accounted for at fair value and classified as

a liability, similar to a cash-settled SAR.

Example SC 3-8 illustrates the accounting for a combination award with a guaranteed minimum value.

EXAMPLE SC 3-8

Grant of awards with a guaranteed minimum value

SC Corporation grants an award of nonvested shares that cliff vest in five years. The award is

structured, such that if the value of the shares does not exceed $1 million, cash will be paid for the

difference between the value of the shares and $1 million on the date the award vests. In other words,

the holder of the shares is guaranteed to receive at least $1 million in value at the date of vesting.

For example, if at vesting the shares have a value of $700,000, the holder would also receive

$300,000 in cash. However, if at vesting the shares have a value of $1.2 million, the holder will receive

no cash.

How should SC Corporation account for this award?

Analysis

This arrangement is effectively a share grant and a written put. The award should be considered a

“combination award,” as defined in ASC 718-10-20, and accounted for in a manner similar to Example

7 in ASC 718-10-55-116 through ASC 718-10-55-130.

The share component should be accounted for as an equity-classified award measured at grant-date

fair value, and the cash-settled put should be liability classified and marked to fair value each

reporting period. Compensation cost for the shares is fixed on the date of grant and recognized over

the vesting period. Compensation cost associated with the cash-settled put liability should be

recognized over the vesting period based on the remeasured fair value at each reporting period until

settlement.

http://www.pwccomperio.com/contents/english/external/us/gaap/718/718-10-20.htm

http://www.pwccomperio.com/contents/english/external/us/gaap/718/718-10-55.htm#p55-116


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3.3.5 Options with underlying shares classified as liabilities

Options or similar instruments are also classified as liabilities when the underlying shares would be

classified as liabilities. Therefore, if the shares underlying an option have repurchase features, a

company should first consider whether the underlying shares would be classified as liabilities. For

example, a public company may grant an option that it would settle by issuing a mandatorily

redeemable share that is not subject to the scope exception in ASC 480. Because the underlying shares

would be classified as a liability, options on those shares would also be classified as a liability in

accordance with ASC 718.

3.3.6 Tax withholding on stock awards

A stock-based compensation plan may permit shares that would otherwise be issued upon an

employee’s exercise of an option or vesting of a restricted stock award to be “withheld” as a means of

meeting the employer’s tax withholding requirements for the income the employee will be deemed to

have earned in the period of exercise/vesting. This is effectively an immediate repurchase of the

withheld shares for cash; however, instead of remitting cash to the employee, the employer remits the

cash to the taxing authority on behalf of employee.

Ordinarily, an immediate repurchase of shares would result in liability classification of an award.

However, ASC 718-10-25-18 permits continued equity classification when shares are withheld for this

purpose as long as (a) the employer has a statutory obligation to withhold taxes on the employee’s

behalf and (b) the amount withheld does not exceed the maximum statutory tax rates in the

employee’s applicable jurisdictions. If those requirements are not met, the entire award would be

classified as a liability, not just the amount withheld for tax purposes. This assessment should be done

on a jurisdiction-by-jurisdiction basis rather than using a “blended” rate across jurisdictions for all

employees. If a company used a blended rate, then in those jurisdictions in which that rate exceeds the

maximum statutory tax rate, the associated awards would be classified as a liability.

For jurisdictions that do not have any withholding requirement (certain non-US jurisdictions), or recipients for which no withholding is required (which could apply to non-executive members of the board of directors in the US), any withholding will cause the award to be liability-classified. Additionally, the employee cannot have the ability to require the employer to withhold more than the allowable amount. The maximum statutory tax rates are based on the applicable rates of the relevant tax authorities, including federal, state, and local authorities, including the employee’s share of payroll or similar taxes.

We believe that a company’s convention of rounding up shares to the next whole share for purposes of

meeting the net share settlement requirements does not alter equity classification if the convention is

applied consistently and is not significant in relation to the withheld amount. For example, if the stock

price per share is unusually high, the cash payment for the fractional share may substantively reflect a

cash settlement of the award.

There are further complexities associated with employees who move from one jurisdiction to another

(“mobile” employees). For these employees, companies will need to carefully assess the withholding

requirements in each jurisdiction to determine the amount that represents the maximum statutory tax

rate.


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3.3.7 Awards exercised through broker-assisted cashless exercise

Many public companies offer their employees broker-assisted cashless exercise programs to help the

employees exercise their stock options without having to use their personal funds to pay for the

exercise price. A broker-assisted cashless exercise is the simultaneous exercise of a stock option by an

employee and a sale of the shares through a broker.

A broker-assisted cashless exercise generally occurs as follows:

□ The employee exercises the stock option and authorizes the immediate sale of the shares that

result from the option’s exercise. On the same day that the option is exercised, the company

notifies the broker of the sale order.

□ The broker executes the sale and notifies the company of the sales price.

□ By the settlement date (typically three days later), the company delivers the stock certificates to

the broker.

□ On the settlement date, the broker (a) pays the company the exercise price plus the withholding

taxes and (b) remits the net of the sales proceeds less the withholding taxes to the employee.

A broker-assisted cashless exercise of an employee stock option does not result in liability

classification for the award if both of the following criteria in ASC 718-10-25-16 through ASC 718-10-

25-17 are satisfied:

□ The cashless exercise requires an exercise of the stock options.

□ The company concludes that the employee is the legal owner of all the shares that are subject to

the option (even though the employee did not pay the exercise price before the sale of the shares

that are subject to the option).

Employees can sell shares from the exercise of options or vesting of restricted stock through a broker

into the market and remit proceeds from the sale to the company in an amount that exceeds the

amount permitted to be withheld for tax purposes without causing the award to become classified as a

liability (see SC 3.3.6). In this situation, the company has not cash settled the awards; rather the

company has delivered shares to settle the award and the employee has sold those shares in the

market and remitted cash back to the company to settle the tax liability.

3.3.8 Award with exercise prices denominated in other currencies

ASC 718 requires that an award that is indexed to a factor that is not a market, performance, or service

condition, should be classified as a liability (refer to SC 3.3.1). However, ASC 718-10-25-14 provides an

exception to allow equity classification of certain awards with an exercise price denominated in

currencies other than the currency in which the shares trade. This exception would apply to a company

that grants an award to its employees resident in foreign jurisdictions with an exercise price that is

denominated in either (1) the functional currency of the company’s foreign operation; (2) the currency

in which the employee is paid; or (3) the currency of a market in which a substantial portion of the

entity’s equity securities trades. If one of these exceptions is met, then the award would not be

considered dual-indexed for purposes of ASC 718 and equity classification would be appropriate,

assuming all other criteria for equity classification were met.


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3.3.9 Repurchase features that function as forfeiture provisions

In some instances, companies grant awards to employees that are exercisable at the grant date, but

contain a repurchase feature that enables the company to reacquire the shares for an amount equal to

the original exercise price (or the lower of the current fair value and the original exercise price) if the

employee terminates employment within a specified time period. The purpose of the repurchase

feature is often to permit the employee to “early exercise” an option so that the employee’s holding

period for the underlying stock begins at an earlier date to achieve a more favorable tax position.

The repurchase feature described above may be equivalent to a forfeiture provision and would not

automatically be analyzed as a call right. This feature would not, on its own, require liability

classification of the award. However, the repurchase feature creates an in-substance service period

because the employer can repurchase the shares at the original purchase price if the employee

terminates within the specified time period. Therefore, the requisite service period for such an award

would include the period until the repurchase feature expires. The “early exercise” of an option during

this period would not be considered substantive for accounting purposes and any cash received upon

“early exercise” would be recognized as a deposit liability. Companies should assess the terms of an

award and the surrounding facts and circumstances when determining whether a repurchase feature

such as the one described above represents a forfeiture provision.

3.3.10 Temporary equity classification of redeemable securities

SEC registrants should also consider the requirements of SEC Accounting Series Release No. 268,

Presentation in Financial Statements of “Redeemable Preferred Stocks,” (“ASR 268”) when

determining the appropriate classification of an award. The SEC staff clarified in SAB Topic 14E

(codified in ASC 718-10-S99-1) that ASR 268 (codified in ASC 480-10-S99-1) and related guidance

(including ASC 480-10-S99-3A) are applicable to stock-based compensation. Under this guidance,

SEC registrants with outstanding equity instruments that are redeemable (1) at a fixed or determinable

price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an

event that is not solely within the control of the issuer are required to classify these securities outside

of permanent equity (i.e., as temporary equity in the mezzanine section of the balance sheet).

Although non-SEC registrants (i.e., nonpublic companies) are not explicitly subject to the

requirements of ASC 480-10-S99-1 and ASC 480-10-S99-3A, we believe the most appropriate

classification for these types of instruments for all entities is outside of the equity section.

Certain awards that qualify for equity classification under ASC 718 may require classification as

temporary equity under ASC 480-10-S99-3A, including:

□ Shares that are redeemable at the employee’s discretion after a six month holding period or based

on contingent events.

□ Options with underlying shares that are redeemable at the employee’s discretion after a six month

holding period or based on contingent events.

□ Options with cash settlement features based on contingent events.

SAB Topic 14E clarifies that companies should present as temporary equity an amount that is based on

the redemption amount of the instrument, but takes into account the portion of the award that is

vested. The redemption amount would differ if an award is an option (which generally requires an


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exercise price) compared to a restricted share (which generally has no exercise price). Intrinsic value is

the redemption amount of an option because when an option is settled, the holder receives the

difference between the fair value of the underlying shares and the exercise price of the option. If the

shares underlying an option are redeemable, the holder pays the exercise price upon exercise of the

option and then, upon redemption of the underlying shares, the holder receives the fair value of those

shares. The net cash to the holder from the award, in either scenario, equals the stock option’s intrinsic

value. For a restricted stock award, the redemption amount is fair value, which is generally equal to

intrinsic value because restricted stock does not have an exercise price.

Awards that are subject to the classification requirements of ASC 480-10-S99-3A should be presented

as follows on the grant date:

□ Shares: Begin presenting the grant-date fair value of the share as temporary equity based on the

portion of the vesting period that has passed. If the share is unvested on the grant date, then no

amount is presented as temporary equity on the grant date.

□ Options: Begin presenting the grant-date intrinsic value of the option as temporary equity based

on the portion of the vesting period that has passed. If the option is unvested on the grant date,

then no amount is presented as temporary equity on the grant date.

Under ASC 480-10-S99-3A, if the award is not redeemable currently (e.g., because a contingency has

not been met), and it is not probable that the award will become redeemable, adjusting the amount

recognized in temporary equity is not required until it becomes probable that the award will become

redeemable. However, for such awards that are unvested on the grant date, the redemption amount of

the award as of the grant date (i.e., intrinsic value for options and fair value for restricted stock) should

be reclassified to temporary equity over the requisite service period as the award vests. After the award

is vested, the amount presented as temporary equity should be equal to the redemption amount of the

award as of the grant date. For options that are granted at-the-money (no intrinsic value on the grant

date), no amount will be presented as temporary equity as long as it is not probable that the option or

underlying shares will become redeemable.

Once it becomes probable that the share or option will be redeemed, ASC 718 may require liability

classification of the award. For example, shares and options with redemption features based on

contingent events could be classified as equity under ASC 718 if the contingent event is not probable of

occurring. Once the occurrence of the contingent event becomes probable, the award generally

becomes a liability and, therefore, ASC 480-10-S99-3A is no longer applicable.

If the award is redeemable currently or it is probable that the award will become redeemable and the

award would still be equity-classified under ASC 718 (e.g., a share that is redeemable at the employee’s

discretion after a six-month holding period), the redemption amount presented as temporary equity

should be adjusted at each reporting date by reclassifying the change in the award’s redemption

amount from permanent equity to temporary equity without consideration of the amount of

compensation cost previously recognized in equity. For example:

□ If a restricted stock award that qualifies for equity classification under ASC 718 is redeemable at

fair value more than six months after vesting, and the restricted stock is 75% of the way through

the vesting period at the balance sheet date, 75% of the current fair value of the stock at the

balance sheet date should be presented as temporary equity. The redemption amount presented as

temporary equity for restricted stock, which is based on the current fair value at each reporting


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period, generally will not be equal to the grant-date fair value that is recorded to APIC over the


□ If a redeemable option (or an option on redeemable stock) that qualifies for equity classification

under ASC 718 is 75% of the way through the vesting period at the balance sheet date, 75% of the

current intrinsic value of the option at the balance sheet date should be presented as temporary

equity. The redemption amount presented as temporary equity for an option, which is based on

the current intrinsic value at each reporting period, generally will not be equal to the grant-date

fair value that is recorded to APIC over the requisite service period.

Figure SC 3-2 summarizes the amounts that should be presented as temporary equity for four different

stock-based compensation awards. The examples assume that the awards meet the criteria for equity

classification under ASC 718.

Figure SC 3-2 Impact of ASC 480-10-S99-3A on four different stock-based compensation awards

Award

Amount presented as temporary equity on the grant date

Subsequent adjustments to temporary equity

□ At-the-money option

□ Underlying shares are

puttable at fair value by the

employee after a six-month

holding period

□ Option cliff vests in four

years

□ Grant-date fair value is

$50,000.

□ One year after grant, the

intrinsic value is $100,000.

No amount is presented as temporary equity on the grant date because the option is unvested and has no grant-date intrinsic value.

Because it is probable that the underlying shares will become redeemable, the company should present the current intrinsic value at each reporting date as temporary equity as the option vests.

At the end of the first year, 25% of the intrinsic value, or $25,000, would be reclassified from permanent equity to temporary equity even though only $12,500 (25% of the option’s grant-date fair value) has been credited to equity as compensation cost.

□ At-the-money option

□ Cash settlement feature that

permits the employee to put

the option to the company at

fair value upon a change in

control.

□ Option cliff vests in four

years.


$50,000



No amount is presented as temporary equity on the grant date because the option is unvested and has no grant-date intrinsic value.

The company will not present any amount as temporary equity until the change in control occurs, because the option had no intrinsic value on the grant date and it is not probable that the option will become redeemable. If it becomes probable that the options will be cash settled (i.e., the change in control occurs), the award would become a liability (accounted for as an equity-to-liability modification).


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Award

Amount presented as temporary equity on the grant date

Subsequent adjustments to temporary equity

□ In-the-money option

□ Intrinsic value of $30,000

on the grant date

□ Underlying shares are

puttable at fair value by the

employee after a six-month

holding period.

□ 100% vested on the grant

date.


$50,000.



The intrinsic value of the option, or $30,000, is presented as temporary equity on the grant date because the option is vested and was granted in-the-money.

Because it is probable that the underlying shares will become redeemable, the company should continue to adjust the amount presented as temporary equity to the current intrinsic value at each reporting date.

At the end of the first year, an additional $70,000 would be reclassified from permanent equity to temporary equity, for a cumulative total of $100,000 presented as temporary equity, even though only $50,000 was credited to equity as compensation cost at the grant date fair value.

□ Restricted stock

□ Cliff vests in four years.

□ Immediately vests and

becomes puttable at fair

value by the employee upon

a change in control.


$150,000

□ One year after grant, the fair

value is $200,000.

No amount is presented as temporary equity on the grant date because the restricted stock is unvested.

Over the vesting period, the company should present the grant-date fair value as temporary equity.

At the end of the first year, 25% of the grant-date fair value, or $37,500, would be reclassified from permanent equity to temporary equity.

Because it is not probable that the stock will become redeemable (change in control is not probable until it occurs), the company should not adjust the amount presented as temporary equity to the current intrinsic value (redemption amount, which also happens to be the fair value of the shares) at each reporting date.

If a change in control becomes probable and the put becomes active within six months of vesting, the award would become a liability under ASC 718 (accounted for as an equity-to-liability modification).

If a change in control becomes probable more than six months after the vesting date of the stock, the company should adjust the amount presented in temporary equity to the current fair value in each subsequent period as long as the put is active.


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Application of the guidance in ASC 480-10-S99-3A does not affect the amount or timing of recognition

of compensation cost in the financial statements. Rather, application of this guidance could result in

the reclassification of amounts from permanent equity to temporary equity to highlight the company’s

redemption obligations. Additionally, as long as the redemption amount is at fair value (or for an

option, the market price of the stock less the exercise price of the option), we believe that the

redemption right does not represent a preferential distribution under ASC 480-10-S99-3A, and,

therefore, the company would not be required to apply the two-class method of calculating earnings

per share described in ASC 260-10-45-60B.

3.3.11 Liability or equity classification criteria for awards

Figure SC 3-3 and Figure SC 3-4 summarize the basic criteria for determining the appropriate

classification of a share award and a stock option, respectively. These flowcharts may not address the

appropriate classification of awards with complex or unusual terms.

Figure SC 3-3 Liability and equity classification of a share award

* Companies should also apply the classification and measurement provisions of ASC 480-10-S99-1 and ASC 480-10-S99-3A,

which may require classification of certain amounts outside of permanent equity.


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Figure SC 3-4 Liability and equity classification of a stock option

* Companies should also apply the classification and measurement provisions of ASC 480-10-S99-1 and ASC 480-10-S99-3A,

which may require classification of certain amounts outside of permanent equity.

3.4 Illustration of a liability-classified award

Example SC 3-9 illustrates the accounting for a common liability-classified award. For the sake of

simplicity, long-term versus short-term classification of balance sheet amounts is not considered;

quarterly information is not presented; nor is any of the compensation cost subject to capitalization

under other GAAP.

Refer to TX 17 for guidance on the tax-related aspects of the examples.


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EXAMPLE SC 3-9

Cash-settled SARs with service and performance conditions

On January 1, 20X1, SC Corporation, a calendar year-end company, grants 100,000 cash-settled SARs

with service and performance conditions to five vice presidents (20,000 SARs each). The cash-settled

SARs will cliff vest if each vice president’s department achieves a cumulative revenue total of $3

million over a three-year period that ends on December 31, 20X3 and the vice president is still

employed at that date (i.e., the SARs have a performance condition with a three-year requisite service

period). Historical results lead management to believe that the targets will be achieved and that none

of the vice presidents will cease working for SC Corporation before vesting. All five employees continue

employment for the three-year requisite service period and achieve their targets for vesting in the

SARs. SC Corporation’s common stock has a par value of $0.01 per share.

SC Corporation calculates cumulative compensation cost by taking the total number of SARs that it

granted, multiplied by the percentage of the requisite service period that has been completed,

multiplied by each SAR’s fiscal year-end fair value. The cumulative compensation cost represents the

ending liability balance of the outstanding SARs at the end of the fiscal year and expense is recognized

or reversed each year to adjust the liability to the appropriate ending balance.

The following table summarizes the SARs activities. For simplicity, all SARs are assumed to be

exercised at the beginning of the fiscal year.

(Abbreviations: O/S = Outstanding)

Fiscal year Granted

SARs O/S

Fair value per SAR at 12/31

% Requisite

service provided

Ending liability balance

Annual compensation cost*

20X1 100,000 100,000 $12 33% $400,000 $400,000

20X2 — 100,000 $14 67% $933,333 $533,333

20X3 — 100,000 $17 100% $1,700,000 $766,667

* Ending liability balance (i.e., the cumulative compensation cost) = the number of SARs outstanding × percentage of requisite

service provided × the fair value per SAR at the end of the fiscal year. Annual compensation cost is the change in the liability balance during the year.

Fiscal year

SARs exercised

SARs O/S

Fair value per SAR

Exercised SARs: cash settlement

Liability balance**

Annual compensation cost

At

1/1

At

12/31

20X4 60,000 40,000 $17 $21 $(1,020,000) $840,000 $160,000

20X5 20,000 20,000 $21 $18 $(420,000) $360,000 $(60,000)

20X6 20,000 — $18

$(360,000) $0 $0

** Liability balance is the beginning balance less cash payouts for exercised SARs of $1,020,000 (60,000 * $17), $420,000

(20,000 * $21), and $360,000 (20,000 * $18) in 20X4, 20X5, and 20X6, respectively, plus or minus changes in the stock price for SARs that remain outstanding of $160,000, ($30,000), and nil for 20X4, 20X5, and 20X6 respectively. Since the awards are fully vested, the ending liability for each year equals the number of SAR’s outstanding at the end of each year multiplied by the fair value per SAR at the end of the year.

How should SC Corporation account for cash-settled SARs with service and performance conditions?


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Analysis

SC Corporation records the following journal entries:


Cr. SBC liability $400,000

To recognize compensation expense in 20X1 for the 20X1 award



To recognize compensation expense in 20X2 for the 20X1 award



To recognize compensation expense in 20X3 for the 20X1 awards

On January 1, 20X4, 60,000 SARs are exercised at a fair value of $17 per SAR, resulting in a cash

payment of $1,020,000 (60,000 × $17).

Dr. SBC liability $1,020,000

Cr. Cash $1,020,000

To recognize exercise of 60,000 SARs at a fair value of $17 in 20X4

On December 31, 20X4, the fair value of each SAR is $21 for the 40,000 SARs that are outstanding. SC

Corporation should recognize additional compensation expense for the $4 increase in the fair value.



To recognize compensation expense in 20X4 for the 20X1 awards

On January 1, 20X5, 20,000 SARs are exercised at a fair value of $21 per SAR, resulting in a cash

payment of $420,000 (20,000 × $21).

Dr. SBC liability $420,000

Cr. Cash $420,000



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On December 31, 20X5, the fair value of the 20,000 SARs that remain outstanding is $18 each. SC

Corporation adjusts its compensation expense to reflect the $3 decrease in the fair value. Therefore, an

adjustment of $60,000 reduces the SBC liability to $360,000.


Cr. Compensation expense $60,000

To adjust the SBC liability to its fair-value amount at the end of 20X5

On January 1, 20X6, the final 20,000 SARs are exercised at a fair value of $18 per SAR, resulting in a

cash payment of $360,000 (20,000 × $18).


Cr. Cash $360,000


Chapter 4: Modifications to stock-based compensation awards

Modifications to stock-based compensation awards

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4.1 Overview of modifications to stock-based compensation awards

ASC 718 defines a modification as a change in the terms or conditions of a stock-based compensation

award. Examples of a modification include a repricing, an extension of the vesting period, changes in

the settlement terms, and changes in the terms of a performance condition. In addition, a change in

circumstances that results in a change in the classification of the award (e.g., equity to liability), even if

there is not a legal modification, may result in a modification. For example, a company may cash settle

awards, which it concludes causes the remaining awards to become in substance liabilities and,

therefore, causes the awards to be modified from equity awards to liability awards.

ASC 718-20-35-2A clarifies when to account for a change to the terms or conditions of a share-based

payment award as a modification. Modification accounting is required only if (1) the fair value, (2) the

vesting conditions, or (3) the classification of the award (as equity or liability) changes as a result of

the change in terms or conditions. Regardless of whether the change to the terms or conditions of the

award requires modification accounting, the existing disclosure requirements and other aspects of

GAAP associated with modifications continue to apply. For example, the earnings per share guidance

requires treating a modification as if there was a cancellation and new issuance of an award in

computing diluted EPS as described in FSP 7.5.5.5. Throughout this chapter it is assumed that changes

to the award’s terms or conditions meet one of the above three conditions and, therefore, require

modification accounting.

As discussed further in this chapter, a company modifying an award under ASC 718 will, generally, (1)

calculate the incremental fair value of the modified award and (2) assess the effect of the modification

on the number of awards expected to vest, including a reassessment of the probability of vesting (for

awards with service and/or performance conditions).

Under ASC 718, the assumptions that a company uses to determine the original award’s fair value

immediately before the modification should reflect the current facts and circumstances on the

modification date. For example, a company should update its volatility and expected term assumptions

to reflect conditions as of the modification date.

4.2 Overall principle for modifications to stock-based awards

A modification is viewed as the exchange of the original award for a new award. When measuring the

compensation cost of a modification of an equity-classified award with a performance or service

condition, a company should perform the following steps at the modification date:

1. Calculate any incremental fair value based on the difference between the fair value of the

modified award and the fair value of the original award immediately before it was modified. To

accomplish this, a company would review the stock price and other pertinent factors (e.g.,

assumptions used in its option-pricing model) as of the modification date, and revise its

assumptions to reflect circumstances on the modification date. As part of this step, the

company should also determine whether the modification changes the estimate of the number

of awards that are expected to vest. See SC 4.3.1.

2. Immediately recognize the incremental value as compensation cost for vested awards. For

awards with graded-vesting features, the incremental compensation cost related to tranches


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that are legally vested should be recognized immediately regardless of whether the company is

applying the graded-vesting or straight-line attribution method to recognize compensation

cost.

3. Recognize, on a prospective basis over the remaining requisite service period, the sum of the

incremental compensation cost and any remaining unrecognized compensation cost for the

original award on the modification date.

Typically, total compensation cost that is recognized for a modified equity-classified award should, at a

minimum, equal the grant-date fair value of the original award. If, on the modification date,

management does not expect the original performance or service condition to be achieved, the

compensation cost that the company recognizes might be lower than the award’s grant-date fair value.

If management expects that the original award would not vest and, after the modification, believes that

the modified award also will not vest, the company should not recognize any compensation cost until it

becomes probable that the modified award will vest. For further details, see SC 4.3.1.

4.2.1 Modifications of liability-classified awards

The general principle of exchanging the original award for a new award also applies to a modification

of a liability-classified award. Unlike an equity-classified award, however, a liability-classified award is

remeasured at fair value at the end of each reporting period. Therefore, a company simply recognizes

the fair value of the modified award by using the modified terms at the modification date. There is no

“floor” or requirement to recognize at least as much as the grant date fair value of a liability classified

award; the total compensation expense will equal the fair value on the settlement date.

4.2.2 Measurement date for modifications of awards

Although there is limited guidance on determining the modification date, we believe it is generally

appropriate to apply the concepts used for determining the grant date of an award. In other words, the

modification date is typically the date that the modified award is approved and there is a mutual

understanding of the modified terms and conditions. A company should account for the modification,

and measure the incremental fair value of the modified award, on the modification date. Refer to SC

2.6.1 for further discussion of determining the grant date.

In some situations, a modification may result in two measurement dates: (1) the date the terms of the

award are modified in anticipation of a future event and (2) the date the event occurs that triggers

modification of the award. An example of a modification with two measurement dates is included in

Example 13 of ASC 718-20-55-103 through ASC 718-20-55-106. In this example, an award that does

not originally contain antidilution provisions is modified on July 26 to add antidilution provisions in

contemplation of an equity restructuring. On September 30, the equity restructuring occurs. As a

result, the company effectively modified the award on both July 26 and September 30. The company

should compare the fair value of the award immediately before and after the modifications on both

July 26 and September 30. See SC 4.5.3 for additional information.

4.3 Modifications of awards classified as equity

Modifications of equity-classified awards may take many forms. Some of the more common

modifications are a change in vesting conditions or a repricing of options.


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4.3.1 Modifications of performance or service conditions

Under ASC 718-20-35-3 through ASC 718-20-35-4, a modification of an equity-classified award should

be accounted for as follows:

□ A company should recognize compensation cost in an amount at least equal to the award’s grant-

date fair value, unless the company’s expectation on the modification date is that the employee

will fail to meet the original award’s performance or service condition.

□ Compensation cost should be recognized if the award ultimately (1) vests under the modified

vesting conditions or (2) would have vested under the original vesting conditions. If the award was

expected to (and does) vest under the original conditions, the company would recognize

compensation cost regardless of whether the employee satisfies the modified condition. This is

consistent with ASC 718’s use of the modified-grant-date model whereby compensation cost is not

reversed for awards that vest, even if an employee does not exercise the option or does not realize

any value from the exercise of the option.

Whether it is probable that an award will vest is an important factor in the recognition of

compensation cost before and on the modification date. ASC 718 uses the term probable in a manner

consistent with its definition in ASC 450, Contingencies, which refers to an event that is likely to occur

(ASC Master Glossary). On the modification date of an equity-classified award, management should

assess the probability that either the original or modified vesting condition will be satisfied. For

awards with performance conditions, a probability assessment is already required each reporting

period. Bearing in mind that an element of subjectivity goes into interpreting the terms probable and

improbable, management should develop, document, and consistently apply a methodology for

assessing the probability of achieving vesting conditions, which should be based on reasonable

assumptions and all available objective evidence.

Modifications of equity-classified awards that have performance and/or service conditions can be

categorized into four types. Examples of the four types of modifications can be found in ASC 718-20-

55-107 through ASC 718-20-55-121.

Type I: Probable-to-probable: This type of modification does not change the expectation that the

award will ultimately vest. The cumulative amount of compensation cost that should be recognized is

the original grant-date fair value of the award plus any incremental fair value resulting from the

modification. A Type I modification will result in incremental fair value if terms affecting the estimate

of fair value have been modified (e.g., a repricing or a modification that affects expected term). The

original grant-date fair value represents the minimum or “floor” amount of compensation to be

recognized if either the original or the modified conditions are satisfied.

Type II: Probable-to-improbable: This type of modification changes the expectation that the

award will ultimately vest. Specifically, a condition that the company anticipates will be satisfied is

replaced with a condition that the company expects will not be satisfied. Type II modifications are

relatively uncommon because employees are unlikely to accept this kind of change unless they receive

other compensation or the company also changes other terms of the award. For Type II modifications,

no incremental fair value would be recognized unless and until vesting of the award under the

modified conditions becomes probable. If the original vesting conditions are satisfied, compensation

cost equal to the award’s original grant-date fair value would be recognized, regardless of whether the

modified conditions are satisfied.


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Type III: Improbable-to-probable: This type of modification changes the expectation that the

award will ultimately vest. Specifically, a condition that the company expects will not be satisfied is

changed to a condition that the company expects will be satisfied. In this fact pattern, the cumulative

compensation cost recognized for the original award should be zero immediately prior to the

modification as none of the awards are expected to vest. The incremental fair value is therefore equal

to the fair value of the modified award (the value of the modified award compared to its prior zero

value). The incremental compensation cost is recognized over the remaining requisite service period, if

any. A Type III modification could result in the recognition of total compensation cost less than the

award’s grant-date fair value because at the modification date, the original vesting conditions are not

expected to be satisfied.

Type IV: Improbable-to-improbable: This type of modification does not change the expectation

that the award will ultimately not vest. The company would not recognize additional compensation

cost on the modification date because it continues to expect that the award will not vest. Therefore, no

cumulative compensation cost should be recognized for the award. If, at a future date, the company

determines it is probable the employees will vest in the modified award, it should recognize

compensation cost equal to the fair value of the award at the modification date. Similar to a Type III

modification, because the original vesting conditions are not expected to be satisfied as of the

modification date, the grant-date fair value is no longer relevant. In other words, a Type IV

modification effectively establishes a new measurement date for the award (the modification date).

4.3.2 Modifications in connection with termination of employment

Companies often decide to modify awards concurrent with an employee’s termination of employment.

For example, this might occur because the employee is a senior executive and a modification is agreed

to in connection with a resignation or involuntary termination in order to avoid an acrimonious

separation. Two common modifications made in connection with termination of employment are: (1)

acceleration of the vesting of unvested awards and (2) extension of the award’s post-termination

exercise period for vested options.

For unvested awards, the company needs to assess whether it expects the original vesting conditions to

be satisfied as of the modification date. If the employee would have forfeited the awards upon

termination according to the awards’ original terms, the awards would not be expected to vest under

the original vesting conditions (i.e., vesting was improbable).

If the employee would have forfeited the awards upon termination under the original terms, and the

company chooses to accelerate vesting or allow continued vesting, the modification is a Type III

modification (improbable to probable). Therefore, incremental fair value is equal to the fair value of

the modified awards on the modification date. This incremental compensation cost is recognized over

the requisite service period, which may result in immediate recognition if the awards do not require

further service, or over the period through a defined date if the employer requires the individual to

work through a specified separation date in order to earn the award. This accounting treatment applies

regardless of the company’s accounting policy for forfeitures (as described in SC 2.7).

In some instances, the original terms of an award provide for automatic acceleration of vesting upon

involuntary termination of employment. When involuntary termination becomes probable, the

accelerated vesting is not treated as a modification (assuming it is consistent with the award’s original

terms) since it is not a discretionary action; however, the requisite service period may have changed.

The change in requisite service period should be recognized on a prospective basis (see SC 2.6.10 for

additional information).


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A modification to extend the exercise period of a vested option is treated as a Type I modification

because it does not change the expectation that the award will vest (i.e., it is already vested).

Incremental fair value is equal to the difference between the fair value of the modified award and the

fair value of the original award (immediately before it was modified). The expected term of the option

prior to the modification should take into account any truncation of term that would occur pursuant to

the option’s original terms upon termination of employment. For example, option plans typically

provide for a 30- to 90-day exercise period after termination of employment. The expected term of the

modified option should consider the new exercise period. An extension of the exercise period generally

results in some amount of incremental compensation cost, assuming no other terms were modified.

Incremental compensation cost is recognized immediately because the options are vested.

Example SC 4-1, Example SC 4-2, Example SC 4-3, and Example SC 4-4 illustrate the accounting for

modifications in connection with termination of employment.

EXAMPLE SC 4-1

Modification to awards in connection with termination of employment – no ongoing service

SC Corporation enters into an agreement with its CFO in connection with the termination of the CFO’s

employment. Under the original terms of the CFO’s stock option award, the CFO would forfeit all

unvested options upon termination of employment and would be permitted a period of 90 days from

the termination date to exercise their vested options. Pursuant to the termination agreement, the

CFO’s outstanding stock options are modified as follows:

□ The exercise period of vested options is extended to one year

□ All unvested options are immediately vested, with an exercise period of one year

The CFO will immediately cease providing services to SC Corporation upon signing of the termination

agreement.

How should SC Corporation account for the modification of the options?

Analysis

The modification of the vested options is a Type I (probable to probable) modification and the

modification of the unvested options is a Type III (improbable to probable) modification.

The modification of the vested options is a Type I modification because the options are already vested

(i.e., the modification does not change the expectation that the awards will vest; the awards are

probable of vesting both before and after the modification). The incremental fair value is calculated as

of the modification date. The fair value of the options before the modification is based on the current

stock price and an exercise period of 90 days, since the original terms of the award permitted only 90

days to exercise upon termination of employment. The fair value after the modification is also based

on the current stock price, but the exercise period should be determined considering the revised one-

year exercise period. This will result in some incremental compensation cost due to the longer

expected term, which should be recognized immediately because the options are vested.

The modification of the unvested options is a Type III modification because prior to the modification,

the unvested options are not probable of vesting as the CFO would have otherwise forfeited the award


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upon termination of employment. Accordingly, any compensation cost previously recognized for the

unvested options should be reversed. The incremental fair value is equal to the fair value of the

modified award, which is measured based on the current assumptions determined as of the

modification date (e.g., the current stock price and an expected term based on a one-year exercise

period). The resulting compensation cost is recognized immediately because the CFO is no longer

providing any service to SC Corporation to earn the options.

EXAMPLE SC 4-2

Modification to awards in connection with termination of employment – continuing service period

SC Corporation granted stock options to its CFO that vest in five equal tranches; one tranche fully

vests at the end of each of the five years. Upon termination of employment, any unvested options are

forfeited and the CFO would be permitted a period of 90 days from the termination date to exercise

their vested options.

Halfway through year three, SC Corporation and the CFO agree to a separation agreement. Pursuant to

the termination agreement, SC Corporation and the CFO agree to the following modifications to the

CFO’s outstanding stock options:

□ The exercise period of vested options is extended from the original 90-day period to one year from

the date of termination

□ All unvested options are immediately vested, with the same one-year exercise period

The CFO will continue to provide service during a transition period of three months from the date the

separation agreement was reached. None of the original awards that were not yet vested would vest

during the three-month transition period based on their original terms. The CFO must complete the

transition period in order to be eligible for the accelerated vesting of unvested options (i.e.,

outstanding unvested options will be forfeited unless the CFO provides service for three additional

months). Assume the compensation cost recognized to date is $700,000 and the fair value of the

modified award is $1,000,000.

How should SC Corporation account for the modification of the options?

Analysis

The calculation of incremental fair value resulting from the modification is the same as described in

Example SC 4-1. The incremental compensation cost calculated for the vested options would be

recognized immediately, consistent with Example SC 4-1.

For the unvested options, the recognition of compensation cost will depend on whether SC

Corporation elects to estimate forfeitures or to account for forfeitures when they occur. If SC

Corporation’s policy is to estimate forfeitures, it would reverse the compensation cost previously

recognized and recognize the entire fair value of the modified award over the remaining three-month

service period. If SC Corporation’s policy is to account for forfeitures when they occur, we believe there

are two acceptable views:

□ View A: Assume a substantive forfeiture of the original award occurs on the modification date as it

was exchanged for the modified award at a time when it was not probable of vesting. Therefore,


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the guidance for a Type III (improbable-to-probable) modification should be followed. The

cumulative compensation cost recognized for the original award should be reversed ($700,000)

and the fair value of the modified award ($1,000,000) should be recognized over the remaining

service period. This is the same as the accounting outcome for a company that elects to estimate

forfeitures.

□ View B: Assume forfeiture of the original award does not occur until the CFO terminates

employment. Under this view, the original award is not yet forfeited; therefore, expense should not

be reversed at the time of the modification. Over the remaining three-month service period, SC

Corporation would recognize compensation cost equal to the difference between the modified

award’s fair value (on the modification date) and the previously recognized amount of the grant-

date fair value of the original award ($1,000,000 fair value of the modified award less $700,000

previously recognized compensation cost or $300,000 “incremental compensation cost”). If the

modified award’s fair value is less than the previously recognized compensation cost, SC

Corporation would not recognize any further compensation cost and the difference between the

previously recognized amount and the modified award’s fair value would be reversed upon the

CFO’s termination of service. For example, if the modified award’s fair value was $500,000, no

cost would be recognized over the remaining service period and $200,000 ($700,000 previously

recognized compensation cost less $500,000 fair value of modified award) would be reversed at

termination.

Under either View A or View B, the cumulative amount of recognized compensation cost for the award

will be the same, which is equal to the fair value of the modified award on the modification date.

EXAMPLE SC 4-3

Modification of awards to extend the post-termination exercise period

SC Corporation’s option plan includes terms that allow employees a 30-day period to exercise vested

options upon termination of employment. On January 1, 20x9, SC Corporation modifies the terms of

the plan to extend the post-termination exercise period to 90 days. Assume that all of the options are

probable of vesting and none of the employees are currently expected to terminate employment.

How should SC Corporation account for the modification?

Analysis

The modification is a Type I (probable to probable) modification because the options are probable of

vesting both before and after the modification. SC Corporation should calculate any incremental fair

value resulting from the extension of the post-termination exercise period and the resulting impact, if

any, to the expected term assumption. Because the modification is not being done in connection with

an employee’s termination, the expected term would not necessarily increase by 60 days as a result of

the 60-day increase in the post-termination exercise period. The fair value before the modification

would be based on an expected term for an option with a 30-day post-termination exercise period,

while the fair value after the modification would be based on an expected term for an option with a 90-

day post-termination exercise period.

The determination of the extent to which this modification impacts the expected term assumption will

depend on the relevant facts and circumstances. Any incremental compensation cost would be


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recognized immediately for vested options and over the remaining requisite service period for

unvested options.

EXAMPLE SC 4-4

Modification of awards in connection with termination of employment – WARN Act

SC Corporation announces on September 15 that it will be restructuring its business operations,

resulting in the shutdown of one of its facilities and the termination of 300 employees. The

restructuring, shutdown, and terminations were not probable prior to September 15. SC Corporation’s

restructuring plan falls under the WARN Act, which requires employers with 100 or more employees

to notify affected employees 60 days in advance of a plant closing or mass layoff. Also under the Act,

all employees are legally employed and paid by SC Corporation until the end of the 60-day notification

period (in this case, November 14). The terminated employees will cease providing services

immediately on September 15.

Employees affected by this layoff have unvested options that will legally continue to vest through

November 14 based upon the above provisions, even though no further service is required. Awards

that do not vest by November 14 will be forfeited according to their original terms.

Has SC Corporation modified the terms of the options that will vest between September 15 and

November 14?

Analysis

No. A modification to the terms of the award has not occurred because the continued vesting of the

awards through November 14 pursuant to the WARN Act is deemed to be an original term of the

award. That is, SC Corporation was required to allow vesting of these options under the original terms

of the award, which implicitly included the requirements of the WARN Act. However, SC Corporation

should adjust the requisite service period for these options since further service will not be required

beyond September 15 in order to retain the awards. Accordingly, any unrecognized compensation cost

for options that will vest between September 15 and November 14 should be recognized on September

15.

4.3.3 Modification of stock options during blackout periods

At times, a company will impose blackout periods that suspend employees’ ability to exercise their

stock options. These blackout periods are generally planned in advance to coincide with a company’s

quarterly and annual earnings releases. However, a company may also impose unplanned temporary

or indefinite blackout periods for other reasons.

During these blackout periods, there are circumstances where employees may have outstanding vested

stock options that are due to expire prior to the end of the blackout period. As a result, the employees

will not have the ability to exercise their options prior to the awards being forfeited. For example, a

company may impose a blackout period that is anticipated to be in place for several months. During

that indefinite period, the company may terminate an employee whose vested options expire 30 days

after termination. As a result, the employee will not have the ability to exercise the options prior to the

end of the 30-day post-termination exercise window (i.e., the awards will expire).


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A company may determine that based on the terms of its option plan, certain employees will not have

the ability to exercise their options prior to expiration and the company is under no legal obligation to

deliver any value (e.g., cash) to the employees in lieu of exercising the options. As a result, a company

may decide to extend the options’ term for a period of time to provide their employees with the ability

to exercise their options after the blackout period has been lifted. In these cases, if the holders cannot

exercise and there is no obligation to deliver value to the employee, then the modification to extend

the term beyond the blackout period is considered a Type I modification as the options are already

vested and the modification only impacts the employee’s ability to exercise and not the probability of

vesting. However, when calculating the fair value of the options immediately before the modification,

the fair value is zero because the option holder cannot exercise the option and receive value.

Accordingly, the value transferred to the employee (that is, the incremental fair value) is the full fair

value of the modified option on the date of the modification. Further, because the award was fully

vested prior to the modification, no amount of previously recognized compensation cost (associated

with these options) should be reversed.

When evaluating fact patterns similar to the one described above, careful consideration should be

applied to the particular facts and circumstances, including whether the holders have an ability to

exercise, whether the holder can exercise but not sell the underlying shares, the vesting status of the

options, any legal obligation to deliver value to the employee, and other considerations. Any of these

considerations could impact the accounting result.

At times, the modifications discussed above occur when the holders of the outstanding options are no

longer employees of the company. Pursuant to ASC 718-10-35-10, a share-based award granted to an

employee that is subject to ASC 718 shall continue to be subject to the recognition provisions of ASC

718 throughout the life of the share-based award, unless its terms are modified when the holder is no

longer an employee. As such, once post-employment modifications occur, the modification of the

award should be accounted for pursuant to the modification guidance in ASC 718, but after the

modification, the recognition and measurement of the award should be determined by reference to

other GAAP (e.g., ASC 480 and ASC 815). Application of either of those sections of the codification

could subject the award to liability classification.

We believe modifications that are concurrent with an employee’s termination (for example, extension

of exercise term upon termination of employment) are generally made in consideration of past

employment. Therefore, the award should continue to be accounted for under ASC 718 after the

modification. Judgment may be required in determining whether a modification is concurrent with an

employee’s termination. See SC 4.10 for more information on transitioning from ASC 718 to other

GAAP.

4.3.4 Repricing of unvested options

The repricing of unvested options with a performance or service condition is a modification that

should be accounted for under ASC 718-20-35-3 through ASC 718-20-35-4. A repricing, however,

would not impact the probability of vesting. Assuming the award is otherwise probable of vesting, a

company that makes such a modification should:

□ Measure compensation cost for the difference between the fair value of the modified award and

the fair value of the original award on the modification date


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□ Recognize, over the remaining requisite service period, the sum of the incremental compensation

cost and the remaining unrecognized compensation cost for the original award on the

modification date

Example SC 4-5 illustrates the accounting for repricing of unvested options.

EXAMPLE SC 4-5

Accounting for a repricing of unvested options

On October 1, 20X1, SC Corporation grants its employees 1,000,000 stock options that have an

exercise price of $60 and a three-year cliff-vesting service condition. The options’ exercise price equals

the fair value of the stock on the grant date. The award’s fair value is $35.29. SC Corporation

recognizes compensation cost using the straight-line attribution method. On October 1, 20X2, which is

one year into the three-year requisite service period, the market price of the company’s stock declines

to $40 per share, prompting the company to reduce the options’ exercise price to $40 (no other

changes to the award’s terms were made). SC Corporation calculates the incremental fair value by

calculating the fair value of the award immediately before and immediately after the modification. The

fair value of the award immediately before the repricing is based on assumptions (e.g., volatility,

expected term, etc.) reflecting the current facts and circumstances on the modification date and

therefore, differs from the fair value calculated on the grant date. For simplicity, no pre-vesting

forfeitures were assumed. Other significant information is as follows:

Original award Modified award

Fair value on modification date $18.36 $24.59

Exercise price $60.00 $40.00

Unrecognized compensation cost per option on October 1, 20X2 ($35.29 * 2 years remaining / 3-year vesting period) $23.53 n/a

The additional compensation cost stemming from the modification is $6.23 per option ($24.59 fair

value of modified award less $18.36 fair value of original award on modification date) and the total

compensation cost to recognize prospectively per option is $29.76 ($23.53 remaining unrecognized

compensation cost + $6.23 incremental fair value).

The total remaining compensation cost of $29,760,000 ($29.76 * 1,000,000 options) would be

recognized ratably over the modified award’s two-year requisite service period. Accordingly, SC

Corporation’s compensation cost would be $14,880,000 per year from October 1, 20X2 through

September 30, 20X4.

4.3.5 Modifications of awards to accelerate vesting upon certain events

Many stock-based compensation awards contain provisions that provide for vesting to automatically

accelerate upon a change in control event. Companies also sometimes modify an outstanding award to

add this type of “change in control” provision. As discussed in SC 2.5.3, a change in control of the

company is generally not viewed as probable until it occurs. Thus, a modification to add a change in

control provision does not change the expectation of whether the awards will vest and does not change

the attribution of expense (until the change in control occurs). If the original vesting conditions are

expected to be satisfied as of the modification date, a modification to add a change in control provision


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does not result in any incremental fair value. This is because the awards are expected to vest both

before and after the modification (since the change in control is not yet probable), and the change in

control provision itself does not change the fair value of the award. When the change in control occurs,

the company will recognize the remaining grant-date fair value because the requisite service period

has been completed.

In other instances, companies modify awards to accelerate vesting in anticipation of the sale of a

business unit. For example, a company might accelerate the vesting of awards held by employees of a

business unit that will be sold (who will be terminating employment) because those employees

otherwise would have forfeited the awards. In this scenario, the company should assess whether the

sale of the business is probable at the time the awards are modified. Unlike a change in control, we

believe a sale of a business unit could be probable before it occurs. A company should consider its

assessment of when the business unit meets the held for sale criteria in ASC 360 as that assessment

also involves assessing whether the sale transaction is probable. If the sale is determined to be

probable, the modification to accelerate vesting would likely be a Type III modification (improbable to

probable).

4.3.6 Modifications to the requisite service period of awards

The modification of an award may affect the award’s requisite service period. If the modified requisite

service period is equal to or shorter than the original requisite service period, compensation cost

should be recognized over the remaining portion of the modified requisite service period. For example,

a company grants an award with a performance condition and a four-year requisite service period. One

year after the grant date, the company modifies the original performance condition and replaces it

with a new performance condition that has a two-year requisite service period. The award was

expected to vest both before and after the modification; therefore, it is a Type I (probable to probable)

modification. The company would recognize compensation cost over the modified requisite service

period of two years (as opposed to the remaining portion of the original requisite service period of

three years), starting from the modification date.

If the modified requisite service period is longer than the original requisite service period and, at the

modification date, the original vesting terms are expected to be satisfied, the company should track

whether the employees complete the original requisite service period. ASC 718-20-55-107 requires a

company to recognize compensation cost at least equal to the original grant-date fair value if the

awards ultimately would have vested under the original vesting conditions.

For example, a company grants options with a grant-date fair value of $9 per option and a three-year

service period. Two years after the grant date, the company reduces the options’ exercise price and

increases the service period from the remaining one year of the original vesting requirement to three

years (i.e., requiring two additional years of service). The incremental fair value of the award, as a

result of the modification, is $4 per option. Therefore, the total remaining compensation cost that the

company should recognize is $7 (unrecognized compensation cost for original option of $3 plus

incremental fair value of $4). We believe, there are two approaches to address this issue:

□ Pool approach: Under this approach, the company would recognize $7 over the remaining three

years of the modified requisite service period.

□ Bifurcated approach: Under this approach, the company would recognize (1) the $3 of

unrecognized compensation cost over the original award’s remaining one-year requisite service

period and (2) the $4 of incremental value over the three-year modified requisite service period.


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Under either approach, if an employee does not complete the three-year modified requisite service

period, some or all compensation cost related to the employee’s awards should be reversed depending

on when the employee leaves. If the employee completes one year of service, the compensation cost

related to the original award ($3) should not be reversed, because the employee would have vested

under the original vesting conditions. Either approach is acceptable, and the choice is an accounting

policy decision which should be disclosed in the financial statements, if material, and consistently

applied.

4.3.7 Modifications of awards with market conditions

As discussed in SC 2.5.2, awards with market conditions are measured and accounted for differently

than awards with performance or service conditions. At the grant date, a company does not assess (or

reassess after the grant date) whether it is probable that a market condition will be satisfied, because

the effect of the market condition is reflected in the fair value of the award. Instead, the recognition of

compensation cost is solely dependent upon the employee completing the requisite service.

ASC 718 does not provide specific guidance on how to account for the modification of an award with a

market condition. However, the general principles of modification accounting also apply to awards

with market conditions, except that the accounting is not based on whether the company expects the

market condition to be satisfied as of the modification date. Instead, the market condition is reflected

in the fair value measurements used to calculate incremental fair value on the modification date.

If the employee is expected to complete the requisite service at the time of the modification, a

company will recognize compensation cost equal to the unrecognized grant-date fair value of the

original award plus any incremental fair value (if any) arising from the modification over the

remaining requisite service period.

4.3.8 Modifications of awards by nonpublic companies

Nonpublic and public companies follow the same principles for modification accounting. However, in

some cases, nonpublic companies can elect to use alternative measurement methods, such as

calculated value or intrinsic value, for certain awards (see SC 6). If a nonpublic company is applying an

alternative measurement method, that method should be used instead of “fair value” when calculating

incremental value resulting from a modification.

For example, if a nonpublic company modifies an award measured using calculated value, it should

measure incremental value based on the difference between the calculated value of the modified award

and the calculated value of the original award at the modification date.

Another example is the modification of a liability award measured using intrinsic value. If the

modification causes the award to become equity-classified, intrinsic value is no longer an acceptable

measurement method (except in unusual situations described in SC 2.2.3). Nonpublic companies

generally must use fair value or calculated value to measure equity-classified awards. In this situation,

we believe the incremental compensation cost should be based on the difference between the fair value

(or calculated value) of the modified equity-classified award and the intrinsic value of the original

liability award at the modification date.


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4.4 Modifications that change an award’s classification

As noted earlier, modifying an award may cause an equity-classified award to become a liability-

classified award or vice versa.

4.4.1 Equity-to-liability modification of awards

When accounting for a modification that changes an award’s classification from equity to liability, a

company should do the following:

□ Determine the portion of the requisite service period that the employee has completed.

□ Recognize a liability that equals the modified award’s modification-date fair value, multiplied by

the percentage of the requisite service period completed at the date of the modification. If the

liability equals the amount recognized in equity for the original award, the entry to recognize the

liability is simply a credit to liability and a debit to equity. If the liability exceeds the amount

recognized in equity for the original award, the incremental amount is recognized as compensation

cost currently. If the liability is less than the amount recognized in equity, the residual amount

simply remains in equity, generally as additional paid-in capital.

□ For each reporting period after the modification date, adjust the liability so that it equals the

portion of the requisite service provided multiplied by the modified award’s fair value at the end of

the reporting period. Changes in the liability are recorded as increases or decreases to

compensation cost, except that the amount of compensation cost is subject to the floor of the

original equity award’s grant date fair value. If the liability value declines below the amount that

represents the portion of the requisite service period multiplied by the original equity award’s

grant date fair value, that difference is credited to equity rather than compensation cost. In that

case, compensation cost is being recognized based on the grant date fair value of the original

equity award (rather than the liability value).

An example of a modification that causes an award’s classification to change from equity to liability,

including illustrating the “floor principle,” can be found in ASC 718-20-55-123 through

ASC 718-20-55-133. Example SC 4-6 illustrates the accounting for an equity-to-liability modification.

EXAMPLE SC 4-6

Accounting for a modification that results in a change to an award’s classification

On October 1, 20X1, SC Corporation grants its employees 1,000,000 stock options that have an

exercise price of $60 and a three-year cliff-vesting service condition. The options’ exercise price equals

the fair value of the stock on the grant date. The award’s fair value is $35.29. SC Corporation

recognizes compensation cost using the straight-line attribution method. On October 1, 20X2, which is

one year into the three-year requisite service period, the company decides to issue cash-settled stock

appreciation rights (SARs) to replace the options. The fair value of the SARs (and the original stock

options) is $45 on the modification date.

How should SC Corporation account for the exchange of stock options for SARs?


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Analysis

Because the original award had three-year cliff-vesting provisions, the SC Corporation would have

recognized compensation cost of $11.76 per year per option (1/3 × $35.29). On the modification date

(October 1, 20X2), the fair value of each cash-settled SAR is $45. The company should have recognized

$15 in compensation cost for each SAR (1/3 of the $45 fair value). Because the pro rata fair value of the

liability ($15) is more than the pro rata grant-date fair value of the original award ($11.76), an

adjustment would be made to cumulative compensation cost at the time of the modification. The

company would record the following journal entries:

Through September 30, 20X2:



To recognize stock-based compensation cost for the first year of the award’s service period

On October 1, 20X2 (the modification date):

Dr. Compensation expense

(($15.00 – $11.76) × 1,000,000)

$3,240,000

Dr. Additional paid-in capital $11,760,000

Cr. Stock-based compensation liability $15,000,000

To recognize the effect of the modification

4.4.2 Liability-to-equity modification of awards

The floor principle does not apply to a modification that results in a company reclassifying an award

from a liability to equity. To account for such a modification, a company should do the following:

□ Reclassify the liability as of the modification date to additional paid-in capital

□ Recognize compensation cost equal to the excess, if any, of the modified award’s fair value over the

original award’s fair value immediately prior to the modification. Generally, the equity-classified

award will not be remeasured after the modification date

□ Account for the award as equity, going forward, so long as there are no further changes

An example of a modification that causes the award’s classification to switch from liability to equity

can be found in ASC 718-20-55-135 through ASC 718-20-55-138.

4.5 Modifications to awards in an equity restructuring

Changes that awards undergo as a result of an equity restructuring (e.g., large non-recurring cash

dividend, stock split, spin-off, etc.) are modifications under ASC 718.


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Often, companies will adjust an award’s terms to preserve its value after such an equity restructuring.

Some awards may contain terms that require or allow for the adjustment of an award to protect the

holder from changes in the award’s value following an equity restructuring, commonly referred to as

“antidilution provisions.” For example, to offset the decrease in the per-share price of the stock

underlying an option after a stock split or spin-off, a company may adjust the exercise price, the

number of shares, or both. To determine whether these changes result in incremental compensation

cost under ASC 718, companies will first need to assess whether the adjustments were required by the

award’s existing terms.

An adjustment to the terms of a stock-based compensation award to preserve its value after an equity

restructuring may result in significant incremental compensation cost if there was no requirement to

make such an adjustment based on the award’s existing terms. Plan terms that merely permit

adjustment of an award at the discretion of management or the compensation committee will not

prevent a company from incurring additional compensation cost because such a provision does not

require an adjustment if an equity restructuring event occurs.

4.5.1 Modifications of awards without an antidilution provision

If the adjustment of an award’s terms in an equity restructuring was not required by its existing terms,

the modification will likely result in incremental fair value because the award’s fair value immediately

before the modification contemplates the equity restructuring occurring but does not contemplate

antidilution protection (i.e., protection against a decline in the value of an award upon restructuring).

The fair value immediately after modification reflects the “equitable” (antidilution) adjustments to the

award’s terms, which will increase its value relative to the award that is not adjusted.

Equity restructurings in which award holders receive a cash payment in lieu of modifying the award

are also treated as a modification. Similar to the illustration in Example SC 4-7, the value of the award

without the cash payment (i.e., the immediately before value) is compared to the value of the

unmodified option together with the cash payment (i.e., the immediately after value of the entire

award provided the holder). Any incremental fair value transferred to holders of vested awards would

be recorded as compensation cost. For those awards that have not vested upon modification, the

recognition of compensation cost for the portion of the arrangement that was settled in cash is

accelerated (assuming the cash received by the employee is fully vested and does not need to be

returned if the underlying award never vests). In equity restructurings, any change in the exercise

price or other terms of the option, as well as the cash payment, should be included in the assessment

of whether incremental fair value has been provided to the award holders.

Example SC 4-7 illustrates the accounting for the modification of stock options to preserve their value

after a 2-for-1 stock split, assuming that the options do not contain an antidilution provision.

EXAMPLE SC 4-7

Modification of stock options without an antidilution provision for a stock split

On June 1, 20X1, SC Corporation grants 10,000 “at-the-money” equity-classified stock options with an

exercise price of $20 and a grant-date fair value of $9.03. The options cliff-vest in four years based on

a service condition. The options’ original terms do not include antidilution protection (i.e., the plan is

silent on the subject of preserving the options’ value upon a future equity restructuring event).


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One year after the grant date, SC Corporation completes a 2-for-1 stock split of its common stock when

the market price of its stock is $50. Concurrent with the stock split, SC Corporation modifies the

options so that the exercise price is adjusted to $10 and the number of options outstanding is

increased to 20,000. The modification is intended to preserve the value of the options after the stock

split.

All valuation assumptions remain constant before and after the modification: expected volatility of

40%, expected term of 6 years, dividend yield of 0%, and risk-free interest rate of 4%.

How should SC Corporation account for the stock split?

Analysis

Because the options’ terms do not contain an antidilution provision, the estimated fair value of the

options immediately before the modification should be based on the assumption that the market price

of SC Corporation’s stock will be reduced to $25 as a result of the stock split and the exercise price of

the options will remain at $20. Using a Black-Scholes model and a stock price of $25, an exercise price

of $20, and the other assumptions noted above, the fair value per option immediately before the

modification is $13.05. The total compensation cost for the options outstanding immediately before

the modification is $130,500 ($13.05 × 10,000 options).

Immediately after the modification, the value of the options is based on the new exercise price of $10

and the number of options increases to 20,000. Using a Black-Scholes model, the stock price of $25

and an exercise price of $10, the fair value per option is $17.88. The total fair value of the award

immediately after the modification is $357,600 ($17.88 × 20,000 options).

Thus, this modification, which was intended only to make the option holders “whole,” results in

incremental fair value, and, in turn, compensation cost of $227,100 ($357,600 – $130,500). The

following table summarizes the effect of the modification:

Immediately before the modification

Immediately after the modification

Market price of SC Corporation’s stock $25* $25

Exercise price $20* $10

Fair value per option $13.05* $17.88

Number of options 10,000* 20,000

Total award fair value $130,500* $357,600

* Although the market price of SC Corporation’s stock is $50 prior to the 2-for-1 stock split, the market price is assumed to be

$25 immediately before the options’ modification as it is assumed that market participants would anticipate the stock split whendetermining the options’ fair value.

SC Corporation would recognize the remaining original grant-date fair value plus the incremental fair

value at the date of the stock split as compensation cost over the remaining requisite service period.


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4.5.2 Modifications of awards with an antidilution provision

If awards are adjusted based on an existing antidilution provision that requires the adjustment in the

event of an equity restructuring, and is properly structured to preserve the value of the awards upon

completion of the equity restructuring, incremental fair value generally should not result from the

modification. In this situation, the fair value of the award immediately before the modification will

reflect the required adjustment to the award’s terms in accordance with the antidilution provision.

Thus, the fair value of the award immediately before the contractually-required modification should be

equal to its fair value immediately after the contractually-required modification. However, this

calculation should be performed to confirm that no incremental fair value is generated by the

modification. As described in SC 4.5.4.3, the value used in keeping an award holder “whole” may not

be the fair value of the award for accounting purposes and, as a result, modifications may

inadvertently result in incremental fair value that would need to be recognized.

In order for a company to conclude that a modification is required, we believe the terms of the award

need to, at a minimum, specify that an “equitable” or “proportionate” adjustment is required (not just

that the company “may” make such an adjustment). In our view, it is not necessary for an antidilution

provision to specify exactly how the awards will be adjusted. When assessing whether an antidilution

provision is discretionary, consideration should be given to whether the employees could require the

company to make “equitable” adjustments to an award’s terms if an equity restructuring event occurs.

In some cases, input from legal counsel may be necessary.

4.5.3 Awards modified to add an antidilution provision

A modification also occurs when an antidilution provision is added to an award’s terms. However, ASC

718 provides that if an award is modified to add an antidilution provision and the provision is not

added in contemplation of an equity restructuring event, then the company is not required to calculate

the incremental fair value of the modified award.

If an antidilution provision is added in contemplation of an equity restructuring event, modification

accounting is required and would likely result in incremental fair value and, in turn, additional

compensation cost. Similar to Example SC 4-7, the fair value immediately before the modification to

add the antidilution provision would reflect the anticipated effect of the equity restructuring and

assume no antidilution protection. ASC 718 does not define “in contemplation,” but Case B of Example

13 of ASC 718-20-55-105 indicates that once an equity restructuring event has been publicly

announced, a modification would be considered “in contemplation.” Prior to the announcement of an

equity restructuring event, judgment will be required to determine whether the antidilution provision

was added in contemplation of that event.

4.5.4 Modifications of awards in a spin-off transaction

In a spin-off, a company distributes shares of a subsidiary to its shareholders, thereby reducing the

parent company’s share value. Consider a situation in which the parent company’s market value was

$30 per share immediately before the spin-off. The parent company distributes one share of the

subsidiary’s stock for each parent company share outstanding. Immediately after the spin-off, the

parent company’s shares trade at $25 per share, and the subsidiary’s shares trade at $5 per share.

Companies will generally modify outstanding awards to keep employees in an equitable position after

the spin-off. For example, employees holding options to purchase shares of the parent may receive

options to purchase shares of the entity that has been spun off, or the exercise price and number of


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options on the parent company shares may be adjusted to reflect the decline in value of the parent

company stock. Companies can use a variety of methods to keep employees “whole” upon the spin-off.

Regardless of the method used, any exchange of awards or adjustment in connection with a spin-off

transaction is accounted for as a modification in accordance with ASC 718. A spin-off generally creates

a number of complex stock-based compensation issues. In this section, the following aspects of a

stock-based compensation modification involving a spin-off are addressed:

□ Nature of the modification

□ Impact of a mandatory antidilution provision

□ Stock prices used in the incremental fair value calculation

□ Attribution of stock-based compensation cost

4.5.4.1 Nature of award modifications in a spin-off transaction

Understanding the form of the transaction and how share-based awards will be modified in connection

with a spin-off is important to appropriately account for the modification. The fair value of the award

immediately prior to the modification will be compared to the fair value of the award(s) immediately

after the modification. Common examples of how companies modify awards to preserve the pre-spin

value include providing employees with incremental awards in the parent company stock, providing

awards in the former subsidiary’s stock, or adjusting the exercise price of the existing awards.

Different information is required to account for the modification depending on its nature. For

example, if the company provides existing option holders with options of the former subsidiary, it will

be necessary to estimate the fair value of the subsidiary in order to measure the fair value of those

options.

Options granted on the equity of another entity are derivatives under ASC 815. However, a company

that grants an option on its subsidiary as an equitable adjustment pursuant to an antidilution

provision would still be subject to ASC 718 at the time of grant. If the parent company grants awards in

the former subsidiary after the spin-off, those awards would be derivatives subject to ASC 815-10-55-

46 through ASC 815-10-55-48.

4.5.4.2 Impact of a mandatory antidilution provision

Antidilution provisions are designed to equalize the value of awards before and after the spin-off.

Whether awards contain an antidilution provision will impact the assumptions used to measure the

fair value of the awards upon modification. The fair value immediately before the spin-off for awards

that include an antidilution provision will reflect the required adjustment in accordance with the

antidilution provision (e.g., an increase in the number of awards). The absence of an antidilution

provision will usually result in significant incremental fair value. See SC 4.5.1 through SC 4.5.3 for

further guidance.

4.5.4.3 Stock prices used in calculating incremental fair value

If the equitable adjustment for the spin-off will result in the parent company distributing stock options

in the former subsidiary to the parent’s employees based on the spin-off ratio received by all

shareholders, then the measurement of incremental compensation cost to be recorded by the parent

company is based upon the fair value of the parent company stock options immediately prior to the


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spin-off as compared to the fair value of the parent company stock options plus the former subsidiary

stock options to be distributed upon the spin-off.

The fair value of the parent company awards immediately prior to the spin-off should generally be

based on the parent company’s closing stock price on the day of the spin-off transaction, also known as

the “record date.” In many spin-offs, the parent company’s shares will begin trading on an “ex-

dividend” basis three business days before the record date, (i.e., the parent company’s shares will trade

excluding the fair value of the subsidiary’s shares). After the subsidiary’s registration statement is

declared effective, the subsidiary’s shares will generally begin trading on a “when issued” basis. In this

situation, in order to determine the fair value of the parent company’s shares immediately prior to

spin-off, the fair value of the parent company’s shares traded on an “ex-dividend” basis should be

added to the fair value of the dividend of the subsidiary’s shares traded on a “when issued” basis

immediately prior to the spin-off.

The fair value of the parent company awards immediately after the modification should generally be

based on one of the following:

□ The parent company’s opening stock price on the day after the spin-off (assuming the parent

company shares were not traded on an “ex-dividend” basis);

□ The difference between the closing price of the parent company’s stock on the day of the spin-off

(“before” the spin-off) and the closing price of the subsidiary’s stock (either actual or “when

issued”) on the day of the spin-off; or

□ The parent company’s shares if traded on an “ex-dividend” basis (it would not be necessary to

deduct the closing price of the subsidiary’s stock on the day of the spin-off, because it will already

be reflected in the fair value of the parent company’s shares).

The fair value of the subsidiary’s options immediately after the modification should generally be based

on either:

□ The subsidiary’s opening stock price on the day after the spin-off (assuming the subsidiary’s

shares were not traded on a “when issued” basis), or

□ The closing price of the subsidiary’s stock on the day of the spin-off (assuming the subsidiary’s

shares were traded on a “when issued” basis).

The use of an average price over a period of time, while perhaps deemed “equitable” for purposes of

determining the terms of the modified awards, is not appropriate for purposes of determining fair

value as of the modification date because the use of such averages introduces effects from market

conditions or events other than the equity restructuring itself. The other assumptions used to estimate

fair value (e.g., volatility, expected term, etc.) would also be determined based on the facts and

circumstances immediately before and immediately after the spin-off transaction; however, the fair

value of the awards immediately before the modification should generally include the effects of the

contemplated transaction. Furthermore, volatility and dividend yield assumptions should be

determined separately for the options to purchase parent and subsidiary shares. These assumptions

may differ for the parent and subsidiary depending on the facts and circumstances.


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4.5.4.4 Attribution of stock-based compensation cost

In connection with a spin-off and as a result of the related modification, employees of the parent

company may receive stock-based compensation awards of the former subsidiary, or employees of the

former subsidiary may retain stock-based compensation awards of the former parent company. The

parent company and the former subsidiary would recognize compensation cost related to the modified

awards that had been granted to employees who provide service to each respective entity. In other

words, after the spin-off, each employer would recognize expense only for the stock-based

compensation awards that are held by its employees, regardless of which company originally issued

the awards.

Awards held by parent company employees would continue to be recognized in the financial

statements of the parent company, including any incremental fair value created as a result of the

modification.

If the employees of the former subsidiary were to retain their unvested awards of the parent company,

the former subsidiary would recognize in its financial statements the remaining unrecognized

compensation cost (with an offsetting credit to equity) pertaining to those awards over the remaining

requisite service period. If the former subsidiary issued new awards in connection with the spin-off

(for example, to keep the holder “whole” as a result of the decline in value of the former parent

company awards upon the spin-off), the aggregate fair value of the awards immediately before and

after the spin-off would be calculated, as described in SC 4.5.4.1. Any incremental fair value would be

recognized prospectively in the financial statements of the former subsidiary for unvested awards.

Incremental fair value for vested awards would be recognized immediately in the financial statements

of the former subsidiary.

After the spin-off, the parent company would not recognize any compensation cost related to its

unvested awards that are held by former employees who now work at the former subsidiary, because

those employees will provide services solely to the former subsidiary post-spin. However, in this

scenario, any incremental fair value arising from the spin modification for vested awards would also be

recognized immediately in the parent company’s consolidated financial statements.

A parent company, in contemplation of a spin-off, may also arrange with its current employees, who

are going to work exclusively for the former subsidiary (upon completion of the spin-off), to exchange

unvested parent company options for unvested options to purchase the new shares of the former

subsidiary pursuant to antidilution provisions. The employees will be terminated from the parent

company following the spin-off, but the service they are providing to the former subsidiary will not be

interrupted. In this situation, the parent company would not reverse the compensation cost recorded

for the options prior to the date of the spin-off (that is, there will not be forfeiture of awards). Rather

the parent company is effecting an exchange of awards pursuant to antidilution provisions in

connection with the transaction. Following the spin-off, the parent company would no longer record

compensation cost related to the unvested awards of the former employees. The remaining fair value

of the unvested awards would be recognized by the former subsidiary.

4.6 Modifications in a business combination

In connection with a business combination, the acquirer may agree to assume existing stock-based

compensation arrangements with employees of the acquiree or may establish new stock-based

compensation arrangements to compensate those employees for postcombination services. These


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arrangements may involve cash payments to the employees or the exchange (or settlement) of stock-

based awards. These replacement awards, in many cases, include the same terms and conditions as the

original awards and are intended to keep the employees of the acquiree “whole” (i.e., preserve the

value of the original awards at the acquisition date) after the acquisition. In other situations, the

acquirer may change the terms of the stock-based awards, often to provide an incentive to key

employees to remain with the combined entity.

Other than providing that the exchange of stock-based compensation awards in a business

combination should be accounted for as a modification (ASC 718-20-35-6), ASC 718 does not provide

specific guidance on the accounting for awards exchanged in a business combination. However, ASC

805, Business Combinations, does include specific guidance on the accounting for awards exchanged

in a business combination; for example, it includes guidance as to whether the fair value of the

exchanged awards should be included as part of the purchase price paid and how to account for the tax

effects of exchanged awards.

For accounting guidance on the effects that a business combination may have on stock-based

compensation arrangement, refer to BCG 3.

4.7 Inducements to exercise stock-based compensation awards

Inducements are offers that are generally designed to encourage holders of stock-based compensation

awards to exercise their awards early and are considered modifications. The accounting treatment for

the modification depends on whether the inducement is short-term (i.e., available for a limited period

of time) or long-term. Although ASC 718 does not specify a time-frame for either category of

inducement, we believe that a limited period of time is generally measured in weeks, not months.

□ Short-term inducements

A short-term inducement is an offer by the entity that would result in modification of an award to

which an award holder may subscribe for a limited period of time. The modification guidance

under ASC 718 applies to short-term inducements only if the employee accepts the inducement

offer. Generally, the modification would be accounted for when the employee accepts the offer.

However, if the employee has the option to withdraw acceptance prior to the end of the offer

period, the modification should be accounted for on the last day of the offer period.

□ Long-term inducements

A long-term inducement is any inducement other than a short-term inducement. In the case of a

long-term inducement, the modification guidance should be applied to all outstanding awards that

are subject to the inducement offer, regardless of whether employees accept the offer.

The ASC 718 definition of a short-term inducement excludes an offer to repurchase or settle an award

for cash. Therefore, a limited time offer to repurchase or settle an award for cash is not a modification.

Rather, the repurchase of an award for cash would be accounted for in accordance with ASC 718-20-

35-7. Refer to SC 4.8.


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4.8 Repurchases and settlements of equity awards

The cash settlement of an award (which could be a share, a stock option, or another share-based

payment instrument) is the repurchase of an outstanding equity instrument. An equity-classified

award that is settled in cash should be accounted for as follows (as per ASC 718-20-35-7):

□ If the award is unvested and probable of vesting, the company should recognize the cash

settlement as the repurchase of an equity instrument concurrent with the acceleration of vesting of

the award. Any unrecognized compensation cost based on the grant-date fair value of the award

would be accelerated and recognized on the settlement date.

□ If the award (vested or unvested) is cash settled at its current fair value as of the settlement date,

no incremental compensation cost should be recognized. If the award is cash-settled for an

amount greater than its fair value, additional compensation cost for the difference should be

recognized along with any remaining unrecognized compensation cost. If the award is settled for

an amount less than its fair value, the entire amount of cash transferred to repurchase the award

should be charged to equity and any remaining unrecognized compensation cost should be

recognized.

□ If the award was not probable of vesting as of the cash settlement date, the fair value of the award

immediately prior to the cash settlement is zero, and any amounts previously recognized as

compensation cost would be reversed (or would have already been reversed). The entire amount

paid to settle the award should be charged to compensation cost.

It is important to distinguish between an award that has been repurchased or settled and an award

that has been modified to change its classification to a liability. If the award has been modified, the

modification is accounted for following the approach described in SC 4.4.1, which could have a

significantly different accounting impact.

The repurchase of an award that is an infrequent transaction, negotiated after the award is granted,

and not pursuant to a pre-existing right of the company, is generally accounted for as a repurchase of

equity in accordance with ASC 718-20-35-7. However, a history of cash settlements may indicate that

the substantive terms of outstanding awards include a cash settlement feature, which could result in

liability classification of those awards. Refer to SC 3 for additional information.

If a company has a pre-existing right to settle an award in cash and had previously intended to settle it

in equity (or a pre-existing call right that it did not previously intend to exercise prior to the holder

bearing the risks and rewards of equity ownership for at least six months) but subsequently changes its

intention, then, even absent any change to the terms of award, the award is considered to have been

modified to a liability-classified award and the accounting described in SC 4.4.1 would apply. Another

example of an award that has been modified is an equity award that is converted to a fixed cash

payment that is earned over a future service period. ASC 718-20-55-144 provides an example of this

type of modification.

4.8.1 Repurchase of stock held by an employee

When a company (or a related party or other holder of an economic interest) repurchases stock held by

employees, it is important to consider the accounting requirements in ASC 718-20-35-7. This guidance

indicates that any excess of repurchase price over the fair value of the instrument repurchased should

be recognized as compensation cost.


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We believe the repurchase guidance in ASC 718 should generally be applied even if the shares

repurchased from employees are vested and were not originally issued as compensation (e.g.,

founder’s stock). In some fact patterns, judgment may be required to determine whether the

repurchase of stock results in compensation expense, including whether the price paid is greater than

fair value.

4.8.2 Sale of employee stock in the secondary market

The market for private company equity securities, often referred to as the “secondary market,”

continues to expand. Sales of employee shares to a third party in a secondary market transaction can

introduce unique accounting challenges.

A purchase by a third party of shares from an employee, at fair value, is typically a transaction among

shareholders, with no accounting recognition by the company. However, if the transaction price paid

by the third party exceeds the fair value of the shares, the company will need to evaluate whether there

is a compensatory element to the arrangement. In particular, if the company is involved in facilitating

the transaction, it is likely that compensation expense will arise. Consideration of the extent of the

company’s involvement should include whether the company helped to arrange the transaction and

whether it was concurrent with (or a condition for) a sale of other financial instruments by the

company to the third party.

It is also important to understand the relationship between the company and the third party in the

transaction. If the third party has a pre-existing economic interest in the company, the third party is

presumed to be acting on behalf of the company as described in SC 1.4. In such a situation, unless the

payment is clearly for another purpose, the excess of the purchase price over the fair value of the

shares would be considered compensation for employee services. In that case, the company would

reflect the transaction as a contribution of the excess purchase price from the economic interest holder

and payment of compensation to the employee.

Secondary market transactions often have other complexities. For example, a history of repurchasing

unexercised options or “immature” shares (shares in which the employee has not yet vested or has

vested but which have been held for less than six months) could create a presumption that the

company intends to settle future awards in cash, which would require liability classification for those

awards.

4.9 Cancellation and replacement of equity awards

If a company chooses to cancel an existing equity-classified award along with a concurrent grant of a

replacement award, the transaction should be accounted for as a modification as described in ASC 718-

20-35-8 (see SC 4.2). However, the transaction should only be accounted for as a modification if the

two events occur concurrently. If an award is cancelled without the concurrent grant of a replacement

award, the cancellation should be treated as a settlement for no consideration and all remaining

unrecognized compensation cost should be accelerated. When assessing whether the cancellation and

replacement of awards is a modification, a company should consider the transaction from the

viewpoint of the employee (i.e., whether the employee would view the new award as a replacement of

the cancelled award).

The replacement awards associated with these cancellations may take a number of forms. For

example, a company may choose to cancel an existing equity classified stock option and replace the


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award with cash, vested stock or re-priced options. In cases where the replacement award is vested

stock, the total compensation cost to be recognized by the company is equal to the original grant date

fair value plus any incremental fair value calculated as the excess of the fair value of the stock over the

fair value of the original award on the cancellation date.

In cases in which the company cancels an award and replaces it with an award that includes cash,

there are additional complexities that the company must consider before concluding on the

appropriate accounting for the cancellation and replacement. For example, the replacement of an

unvested equity award for an unvested equity award and vested cash would likely result in the

acceleration of some compensation expense as the cash payment is effectively a settlement for a

portion of the unvested award.

The incremental compensation cost in the examples above should be recognized prospectively over the

remaining service period in addition to the remaining unrecognized grant date fair value.

Example SC 4-8 illustrates the accounting for the cancellation of an equity award that is not probable

of vesting.

EXAMPLE SC 4-8

Cancellation of an equity award that is not probable of vesting

SC Corporation grants equity-classified stock options on January 1, 20x8 to employees that vest based

on achieving a performance target. As of December 31, 20x8, SC Corporation concludes that it is not

probable the performance target will be achieved and, therefore, does not record any compensation

cost. In January 20x9, the board of directors decides to cancel the stock options without a concurrent

grant of a replacement award. The stock options are not probable of vesting on the date of

cancellation.

How should SC Corporation account for the cancellation?

Analysis

Because the award was cancelled without the concurrent grant of a replacement award, SC

Corporation would recognize any remaining unrecognized compensation cost; however, in this

example, the award effectively has no value because it is not probable of vesting. Therefore, we believe

the cancellation of the award has no accounting implications. That is, SC Corporation is not required

to recognize any compensation cost upon cancellation.

4.10 Modifications after an award is earned or after employment

Under ASC 718-10-35-10, an award originally granted as employee compensation will remain subject

to the provisions of ASC 718 throughout the life of the award, unless the award’s terms are modified

when the holder is no longer an employee. At that time, an award may become subject to other

applicable GAAP. Such a modification is accounted for under ASC 718; however, following the

modification, the award would cease to be accounted for under ASC 718 and would become subject to

the recognition and measurement requirements of other applicable GAAP (e.g., ASC 480 or ASC 815).

ASC 718 and other GAAP provide differing guidance for determining whether a freestanding financial


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instrument should be classified as a liability or as equity and in some cases, differing fair value

measurement guidance (e.g., use of contractual term as opposed to expected term). Therefore, the

accounting for the instrument may change once it becomes subject to other GAAP.

Pursuant to ASC 718-10-35-10A, changes to the terms of an award to reflect an equity restructuring

(see SC 4.5) would not cause the award to become subject to other applicable GAAP if the following

conditions are met:

□ There is no increase in the fair value of the award or the ratio of intrinsic value to the exercise

price remains the same (the holders are made “whole”); and

□ The equity restructuring affects all of the holders of the same class of awards in the same manner.

We believe that a modification to accelerate vesting or extend the contractual term of an award on a

discretionary basis concurrent with an employee’s termination would generally be a modification

made in consideration of past employment and therefore, the award would generally continue to be

accounted for under ASC 718. Modifications that take place when the holder is no longer an employee

(other than as described in ASC 718-10-35-10A) may result in the award becoming subject to other

applicable GAAP. For example, the repricing of the exercise price or extension of the contractual term

of a vested award held by a former employee would result in the award becoming subject to other

GAAP. As noted in SC 4.3.3, judgment may be required to determine whether a modification is

concurrent with an employee’s termination.

After the adoption of ASU 2018-07, Compensation—Stock Compensation (Topic 718): Improvements

to Nonemployee Share-Based Payment Accounting, similar guidance will apply to awards granted to

nonemployees. That is, nonemployee awards will be subject to the guidance in ASC 718 throughout the

life of the award unless the terms are modified after the nonemployee earns the award and is no longer

providing goods or services to the company.

After the adoption of ASU 2019-08, Compensation—Stock Compensation (Topic 718) and Revenue

from Contracts with Customers (Topic 606): Codification Improvements—Share-Based

Consideration Payable to a Customer, similar guidance will also apply to awards granted to

customers. That is, awards issued to customers will be subject to the guidance in ASC 718 throughout

the life of the award unless the terms are modified after the grantee earns the award and is no longer a

customer of the company. See SC 7.2.7.4 for further discussion.

Prior to adoption of ASU 2018-07, nonemployee awards (including those issued to customers) cease

being subject to the guidance in ASC 505-50 and ASC 718 after performance occurs, and from that

point forward are in the scope of other applicable GAAP. See SC 7.2.11A for further discussion.

Chapter 5: Employee stock purchase plans

Employee stock purchase plans

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5.1 Employee stock purchase plans overview

This chapter addresses the accounting treatment for employee stock purchase plans (ESPPs) under

ASC 718, Compensation—Stock Compensation. The impact of shares issued through ESPPs on EPS is

discussed in FSP 7.4.3.8 and FSP 7.5.5.5. ESPPs generally do not result in a tax benefit to the employer

unless there is a disqualifying disposition. See TX 17.4.1 for guidance addressing the tax accounting

consequences of disqualifying dispositions.

A typical ESPP in the United States is designed to promote broad-based employee ownership of a

company’s stock. By using payroll withholding and avoiding brokers’ commissions, ESPPs give

employees a convenient and economical means of acquiring company shares (usually at a discount).

ESPPs provide favorable tax treatment if the plan meets the tax-qualification conditions of Internal

Revenue Code Section 423.

5.2 Compensatory vs. non-compensatory ESPPs

All ESPPs are considered compensatory (i.e., compensation cost is recognized), unless they satisfy

certain conditions specified by ASC 718-50-25-1.

An ESPP is considered non-compensatory if it meets all of the following conditions:

Condition 1:

The ESPP has:

□ terms that are no more favorable than those that are available to all holders of the same class of

stock; or

□ a purchase discount that (a) does not exceed the per-share issuance costs that would be incurred

through a public offering of stock (a discount of 5% or less is a safe harbor) and (b) if greater than

5%, is reassessed at least annually to confirm that it continues to meet condition (a).

Under ASC 718-50-25-1 and ASC 718-50-55-35, if the purchase discount is greater than 5%, then at

least annually and by no later than the time of first purchase of shares under an ESPP in a given year, a

company should assess whether its ESPP purchase discount rate is greater than estimated issuance

costs per share as a percentage of the stock price at the grant date. If there is no stock offering, the

company should determine a hypothetical amount of issuance costs that would have been incurred

(i.e., the costs avoided by the company by issuing the shares through the ESPP) had there been a stock

offering. The data used to support a discount in excess of 5% should be based on comparable

companies. Consideration should be given to size, industry, stage of business lifecycle, and other

factors that would be considered by the underwriter in pricing an underwritten offering.

The results of each assessment should be applied prospectively. In other words, if the results of a

company’s annual assessment reflect that the ESPP discount is now greater than the company’s third-

party per-share issuance costs, any subsequent grants made through the ESPP should be considered

compensatory. Prior purchases under that ESPP that, at the time of grant met the criteria to be

considered non-compensatory, would continue to be considered non-compensatory.


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Condition 2:

Substantially all eligible employees may participate in the ESPP on an equitable basis.

Generally a non-compensatory plan must be open to substantially all of the company’s full-time

employees. However, restricting eligibility on a country-by-country or entity-by-entity basis would not

result in a compensatory plan as long as all employees within each restricted country or entity are

treated in the same manner.

Condition 3:

The ESPP does not incorporate option features, including any feature that permits the employee to

purchase shares at the lower of the share price on the grant date or at a later purchase date (a “look-

back feature”). The following features would not be considered option features:

□ Employees are given a short time (not more than 31 days) after the purchase price has been fixed

to enter the ESPP.

□ Employees are allowed to cancel their participation in the ESPP before the purchase date and

obtain a full refund of amounts paid.

A plan would be considered compensatory under ASC 718 if the purchase price is not based solely on

the market price of the shares at the date of purchase. For example, if a plan met all other non-

compensatory criteria under ASC 718-50-25-1, but includes a feature whereby employees can acquire

shares at the average trading price of the last five days, the plan would be considered compensatory

because it is not based solely on the market price at the date of purchase.

If an ESPP is considered compensatory, the entire purchase discount from fair value represents

employee compensation. For example, if a company estimated the per-share issuance costs for a third-

party offering at 7% and offered a 15% purchase discount to employees, the entire 15% purchase

discount (as opposed to just the 8% difference) is employee compensation.

For shares purchased by employees under a compensatory ESPP, companies should recognize

compensation cost over the requisite service period. In general, the requisite service period begins on

the enrollment date (i.e., the start of the offering period) and ends on the purchase date. See SC 5.3.2

for further discussion.

5.3 Recognition and measurement of compensation cost for ESPPs

Consistent with other forms of share-based payments, compensation cost for equity awards is

measured as the fair value of the award at grant date.

However, for ESPPs that incorporate some form of a look-back feature, determining the fair value of

the award can be complex. While this guide does not provide comprehensive fair value measurement

guidance, ASC 718 provides some examples of typical ESPP features and implementation guidance for

measuring compensation cost in those cases.


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Notwithstanding the recognition and measurement of compensation cost, any cash withheld from

employees over the course of the purchase period is recorded as a liability on the company’s books,

until such time that the cash is either returned to the employee (either at their election or upon their

termination of employment prior to the end of the purchase period, if allowed or required by the terms

of the ESPP) or used to purchase shares at the end of the purchase period. The cash withheld from

employees’ salaries is viewed as an advance payment of the exercise price of the ESPP award, which is

not viewed as a substantive purchase of stock.

5.3.1 Grant date for ESPPs

The definition of grant date used in ASC 718-50 for ESPPs is consistent with the definition used for

other forms of share-based payments. As such, the grant date for ESPP awards is when (i) the

employer and employee reach a mutual understanding of the key terms and conditions of the award,

(ii) the employer becomes contingently obligated to issue equity instruments or transfer assets to an

employee who renders the requisite service, (iii) the award has been approved by all necessary parties,

and (iv) the employee begins to benefit from, or be adversely affected by, subsequent changes in the

price of the employer’s equity shares.

Most of these criteria are evaluated in the same fashion as described in SC 2.6.1. However, given the

nature of ESPPs, certain of the criteria can be more complex. For example, in an ESPP with a look-

back feature (as described in SC 5.3.4), the final exercise price may be based on the stock price at the

end of the purchase period, which might call into question whether criterion (iv) is met at the start of

the purchase period. However, ASC 718-10-55-83 notes that while the ultimate exercise price in an

award with a look-back feature is not known up-front, it cannot be greater than the share price at the

start of the purchase period. Therefore, the relationship between the exercise price and the current

share price provides a sufficient basis to understand both the compensatory and equity relationship

established by the award. The recipient begins to benefit from subsequent changes in the price of the

grantor’s equity shares as of the beginning of the purchase period; therefore, this criterion is met at the

beginning of the purchase period. Similarly, in a typical ESPP award, all of the terms are made

available to employees in order for them to choose whether to enroll in the plan and elect a

withholding amount as a percentage of salary, often subject to a maximum amount. Employees then

have a short period of time in order to make such elections prior to the start of purchase period. As

referred to in ASC 718-50-35-1, only when the employees have initially agreed to the offer and have

chosen a withholding rate is there a mutual understanding of the key terms and conditions of the

award.

Accordingly, in most circumstances, the grant date will be the start of the purchase period, as all of the

above criteria will typically be met at this date.

There are scenarios when the grant date criteria will not be met until a later date or, conversely, where

a new grant date will subsequently occur. For example:

□ ASC 718-50-55-32 through ASC 718-50-55-33 describe a type of ESPP (a “Type I plan”) where

employees can change their withholding rate and make a catch-up contribution based on the

amount that would have been withheld had the new rate been in effect during the entire purchase

period. While most changes in withholding rates are applied prospectively and accounted for as

modifications (see SC 5.3.6), a Type I plan is economically different because it allows an employee

to elect not to participate (or to participate at a minimal level) in the plan until just before the

exercise date, making it difficult to determine when there truly is a mutual understanding of the

terms of the award. In this case, there may not be a mutual understanding of the terms (and,


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therefore, a grant date) until shortly before the end of the purchase period when the employee has

to make a substantive decision about how much to participate in the plan.

□ A company that undertakes an IPO may establish a new ESPP after completion of the offering, and

allow employees to enroll in the plan during a short period of time after completion of the IPO,

using the IPO date as the start of the purchase period (i.e., a look back feature) and the IPO price

as the look-back price. Employees may also change their election any time within that enrollment

period. While the IPO date may be defined as the beginning of the purchase period of the ESPP, it

is not until the employees are committed to their withholding elections that there is a mutual

understanding of the key terms and conditions of the award. Therefore, the grant date will be

established on that date, and the fair value of the award must be determined incorporating the

company’s stock price on that date and the formulaic terms of the ESPP. If the stock price on that

date is higher than the IPO price, the fair value of the ESPP award will be higher as the award will

be further in the money on the grant date.

□ A company may determine during the purchase period that it will not have a sufficient number of

remaining shares authorized to satisfy all the shares that may be issued under the ESPP through

the end of the purchase period. This could occur, for example, if the stock price declined

significantly during the purchase period and the ESPP has a look-back feature. The lower stock

price at the end of the purchase period would be used to determine the purchase price, leading to a

larger number of shares necessary to satisfy the withholding liability at the end of the purchase

period than initially anticipated. This could be accentuated in the case of ESPPs with multiple

purchase periods and/or reset features, as described in SC 5.3.5 and SC 5.3.6. If the company

authorizes additional shares (including obtaining shareholder approval, if required) as a result,

that would lead to a new grant date for the awards which are dependent upon the newly

authorized shares to be fulfilled.

In this fact pattern, the company may also need to evaluate the terms of the plan to determine

what legal obligation the company has to employees if there are insufficient authorized shares

available to satisfy all of the amounts withheld from employees during the purchase period. If the

company is only required to deliver authorized shares on a pro rata basis in relation to employee

purchase requests, and any excess amounts withheld are simply returned to employees, no further

accounting may be required as this withholding liability is already reflected on the company’s

books (as described in SC 5.3). However, if the company must make the employees “whole” for any

purchase discounts “foregone” as a result of not being able to deliver all of the shares under the

terms of the ESPP, there may be a share-based payment liability for this additional value that

would need to be recognized on a mark-to-market basis until such time as the company can

authorize additional shares in order to be able to settle the obligation in equity.

5.3.2 Requisite service periods for ESPPs

Most ESPPs require participants to be employed on the purchase date and therefore, employees are

required to provide service during the offering period. As a result, the requisite service period for an

ESPP will generally be the time between the start of the offering period and the date the employee

purchases the shares.

Typical ESPPs have shorter requisite service periods than typical employee stock options because of

the constraint on the maximum purchase period required for tax-qualified status under IRC Section

423. The most common purchase period for ESPPs is 6 or 12 months.


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5.3.3 Forfeitures for ESPPs

The ultimate expense for ESPP awards should reflect only those awards for which the requisite service

period is completed. Companies can make an entity-wide accounting policy election for all share-based

payment awards to employees, including ESPPs, to account for forfeitures only when they occur, as

described in ASC 718-10-35-3. If a company makes the policy election to estimate forfeitures, an

estimated forfeiture rate (i.e., the percent of withholdings expected to go unused and revert to the

employee due to termination of employment prior to the purchase date) should be applied in

determining compensation expense when it can be reasonably estimated. In practice, a minimal

forfeiture rate may be appropriate when the ESPP purchase periods are short and anticipated

employee turnover is minimal. The forfeiture rate should be updated for any changes in estimate

throughout the requisite service period and updated for actual forfeitures upon completion of the


5.3.4 Measurement of ESPPs with look-back features

ASC 718-50-55-2 identifies nine different types of look back features found in ESPPs, and provides

guidance for measuring compensation cost for ESPPs with those characteristics. A typical ESPP award

is granted under a Type B plan. This is a plan in which the number of shares an employee can purchase

depends solely on the employee’s withholding election. The fair value of these types of awards

generally consists of the following:

□ A purchase discount (e.g., 15% of the enrollment/grant-date stock price)

□ The fair value of the look-back feature on the enrollment/grant date (which consists of a call

option on 85% of a share of stock and a put option on 15% of a share of stock)

5.3.5

5.3.5.1

Compensation cost for awards under Type B plans should be calculated based on the number of

employees that enroll in the ESPP and the amount of payroll withholdings initially elected by those

employees, along with the application of the specific terms of the ESPP plan to determine the number

of shares of stock that can be purchased with those withholding amounts as of the grant date.

Subsequent changes in withholding rates are discussed in SC 5.3.6 and forfeitures are discussed in SC

5.3.3.

See ASC 718-50-55-2 for details on the other types of look-back features in ESPPs.

ESPPs with multiple purchase periods

Some ESPPs provide for multiple purchase periods during the plan’s offering period. In that case, each

purchase period essentially constitutes a separate tranche of awards for which a separate fair value

and separate expense attribution schedule may be determined, as described in SC 5.3.5.1 and SC

5.3.5.2.

ESPPs with a look back to enrollment date

The fair value of an award under an ESPP with multiple purchase periods that all have a look-back

feature based upon the stock price at the beginning of the offering period enrollment date should be

determined at the enrollment date in the same manner as a stock option award with graded-vesting

(i.e., with a different estimated “option life” for each purchase period). The attribution of expense


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(accelerated or straight-line) should be consistent with a company’s accounting policy for other awards

with graded vesting and service conditions only (see SC 2.8).

Under the accelerated attribution approach, awards under a plan with a two-year offering period with

purchase dates at the end of each six-month period would be accounted for as having four separate

tranches starting on the same initial enrollment date. The requisite service periods for the four

tranches would be 6, 12, 18, and 24 months. Under the straight-line attribution approach, a company

recognizes compensation cost on a straight-line basis over the 24-month requisite service period,

while ensuring that the amount of compensation recorded at each reporting date is at least equal to the

grant-date fair value of the vested portion of the award.

5.3.5.2 ESPPs with a look back to each start period

The measurement and attribution approach for an ESPP with a two-year offering period that includes

four separate six-month purchase periods, each of which has a look-back feature to the stock price at

the beginning of the respective purchase period, differs from the approach when the look back is to the

initial enrollment date that is described in SC 5.3.5.1. When the look back is to the beginning of the

purchase period, compensation cost would be measured and recognized separately and sequentially

(i.e., measured at the beginning of each six-month purchase window and recognized starting at that

date, as that would be the grant date for such tranche) for each of the six-month offering periods. The

fair value of each award would be recognized over its 6-month requisite service period; accelerated

attribution would not be applicable.

5.3.6 Changes in withholding elections and reset features of ESPPs

ASC 718-50-55 provides implementation guidance and examples for a variety of features that may be

found in an ESPP, including resets, rollovers, and changes in withholdings:

□ Reset mechanism: If the market price of the stock at the end of any purchase window is lower than

the stock price at the original grant date (initial enrollment date), the plan resets so that during the

next purchase period an employee may purchase stock at the stipulated discount in relation to the

lower of (a) the stock price at the beginning of the purchase period (rather than the original grant

date price) or (b) the exercise date.

□ Rollover mechanism: If the market price of the stock at the end of any purchase window is lower

than the stock price at the original grant date (initial enrollment date), the plan is immediately

cancelled and a new plan is established using the then-current stock price as the base purchase

price.

□ Variable or semifixed withholdings: Variable withholding features permit an employee to change

the amount of payroll withholdings throughout the purchase period to any amount. Semifixed

withholding features permit an employee to change his or her withholding election at the

beginning of each purchase window.

When or if these plan features occur or are elected by an employee, the changes in the award’s terms

are considered to be modifications, and modification accounting described in ASC 718-20-35-2A

through ASC 718-20-35-9 should be applied. See SC 4 for further guidance on modification

accounting.


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In an ESPP with a reset feature, the look-back purchase price will “reset” if the stock price at a future

purchase date is lower than the stock price on the first day of the offering period. On the date that a

reset feature is triggered, the terms of the award have been modified. As a result of the reset feature,

the employee now has the ability to purchase more shares with the same amount of salary

withholdings as a result of the decrease in exercise price. When determining the amount of

incremental compensation cost, companies should consider the impact of changing both the number

of shares and the exercise price.

If the ESPP permits employees to change their payroll withholdings during the offering period and an

employee elects to do so, the change is accounted for as a modification. If an employee elects to

increase his/her payroll withholdings, compensation cost should be recognized for the additional

shares that the employee will be permitted to purchase.

However, if an employee elects to decrease his/her payroll withholdings or withdraw completely from

the plan (but does not terminate employment), the amount of compensation cost is not decreased. The

accounting for decreases in withholdings is consistent with the requirement in paragraph 718-10-35-3

that the total amount of compensation cost that must be recognized for an award be based on the

number of instruments for which the requisite service has been rendered (that is, for which the

requisite service period has been completed). If an employee does not complete the requisite service

period (i.e., terminates employment prior to the purchase date), the award is forfeited and any

compensation cost related to that employee’s awards would be reversed, as described in SC 5.3.3.

5.4 Classification of ESPPs – liability versus equity

An ESPP with a fixed discount percentage off the purchase date price, no look-back feature, and fixed

withholdings would be liability classified under ASC 718-10-25-7 and ASC 480-10-25-14 until

settlement because it is essentially an award that embodies an unconditional obligation to issue a

variable number of shares for a fixed monetary amount known at inception. Upon settlement, the

liability would be reclassified to equity.

The compensation element of an ESPP with a look-back feature would be equity classified under ASC

718-10-25-7 and ASC 480-10-25-14 as the monetary value of the award is not fixed at the grant date

and the holder is subject to the risks and rewards of equity ownership. As noted in SC 5.3, any cash

withheld from employees during the purchase period would be reflected as a withholding liability until

the shares are purchased.

Chapter 6: Nonpublic company stock-based compensation

Nonpublic company stock-based compensation

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6.1 Nonpublic company stock-based compensation overview

This chapter discusses the key aspects of accounting for a nonpublic company’s stock-based

compensation awards. There are multiple definitions of a “nonpublic company” in US GAAP. ASC 718

contains a specific definition for purposes of applying stock-based compensation guidance, which may

result in a conclusion on the company’s status that differs from that applicable for other aspects of the

entity’s accounting and reporting. For purposes of applying ASC 718, the definition of a nonpublic

company is included in ASC 718-10-20.

ASC 718-10-20

Nonpublic entity: Any entity other than one that meets any of the following criteria:

a. Has equity securities that trade in a public market either on a stock exchange (domestic or foreign)

or in an over-the-counter market, including securities quoted only locally or regionally

b. Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities

in a public market

c. Is controlled by an entity covered by the preceding criteria.

An entity that has only debt securities trading in a public market (or that has made a filing with a

regulatory agency in preparation to trade only debt securities) is a nonpublic entity.

In accordance with this definition, an entity with only publicly traded debt securities is a nonpublic

company under ASC 718, and a subsidiary of a public company is considered a public company.

Additionally, an entity controlled by a public company (e.g., a subsidiary controlled by a private equity

fund that is controlled by a public company) is considered a public company. In assessing the second

criterion of this definition, “making a filing” with a regulatory agency includes both a public filing of a

registration statement or periodic Exchange Act filing as well as a confidential submission of a

registration statement with the SEC as part of preparing for an initial public offering (for example,

under the JOBS Act), even if such document is not legally considered “filed” under the securities laws.

See SC 1.3 for further guidance on the definition of a public versus nonpublic company.

Most of the provisions of ASC 718 that apply to public companies also apply to nonpublic companies.

This chapter discusses the specific differences and other issues unique to nonpublic companies,

including measurement, accounting for mandatorily redeemable financial instruments, and

accounting for book value plans. This chapter also addresses the implications of transitioning from a

nonpublic to a public company and the classification of awards provided to employees of “pass-

through” entities.

6.2 Measurement of awards issued by nonpublic companies

The selection of the appropriate measurement method depends on the classification of the award.

Figure SC 6-1 summarizes alternative measurement methods by nonpublic companies for equity and

liability awards.


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Figure SC 6-1 Measurement methods (nonpublic companies only)

Equity-classified awards Liability-classified awards

Value according to the following hierarchy:

1. Fair value

2. Calculated value if company-specific volatility cannot be estimated

3. Intrinsic value if the terms of an award are so complex that fair value or calculated value cannot be estimated

Accounting policy election:

□ Fair value*

or

□ Intrinsic value

* Nonpublic companies may elect to use the calculated value method to measure liability-classified awards if the calculated value method is used to measure equity-classified awards.

Note about ongoing standard setting

As of the release date of this publication, the FASB has an active project that may provide a practical

expedient for the determination of the current price of an underlying share for equity-classified stock

option awards issued by nonpublic companies. Financial statement preparers and other users of this

publication are encouraged to monitor the status of the project.

6.2.1 Measurement of equity awards by nonpublic companies

Consistent with public companies, the fair value method for awards classified as equity, if practicable

to apply for a nonpublic company, is preferable. The AICPA Practice Aid, Valuation of Privately-Held-

Company Equity Securities Issued as Compensation, provides both valuation and disclosure best

practices related to the issuance of privately-held-company equity securities as compensation,

including awards that are within the scope of ASC 718.

In some cases, nonpublic companies may find it difficult to use the fair value method because of the

difficulty of estimating volatility for use in an option pricing model. Generally, nonpublic companies

can look at volatility of similar (“peer group”) public companies to help determine a volatility

assumption. See SC 9.4.1.2 for a more detailed discussion on how to select an appropriate peer group.

In addition, a nonpublic company that conducts private transactions using its stock or issues new

equity or convertible debt instruments may consider its shares’ historical volatility when estimating

expected volatility.

For the sake of convenience, throughout this guide, the term fair value is intended to be the equivalent

of fair value-based method as used in ASC 718.

6.2.1.1 Use of calculated value method by nonpublic companies

If sufficient information is not available to estimate expected volatility, nonpublic companies may use

the calculated value method. The calculated value method requires the use of an option pricing model

that substitutes the historical volatility of an appropriate industry/sector index for the expected

volatility assumption. A company should first consider other methods, such as applying the fair value


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method using peer group volatility, before utilizing the calculated value approach. We believe most

companies should be able to identify a peer group to estimate expected volatility.

To apply the calculated value method, companies should select an appropriate industry/sector index

(e.g., from the Dow Jones index series), taking into account the nonpublic company’s size. Likewise, if

a nonpublic company participates in two different industries that have experienced different

volatilities, it would need to decide how to average those volatilities for purposes of determining its

own volatility assumption.

Once an appropriate index has been identified, a nonpublic company should use the volatility that

corresponds to the option’s expected term. For example, if the expected term of the nonpublic

company’s option is five years, it should use the five-year volatility of the appropriate index.

6.2.1.2 Use of intrinsic value method by nonpublic companies

As discussed in SC 2.2.3, in some rare circumstances, it might not be possible to reasonably estimate

the fair value or the calculated value of equity-classified awards on the grant date because of the

complexity of the award’s terms. In these limited situations, a nonpublic company should use the

intrinsic value to measure the value of the award. The company should then remeasure the intrinsic

value each reporting period until the award is exercised, settled, or expires, even if the company might

be able to reasonably estimate the fair value at a later date. Thus, the final measurement of

compensation cost would be the award’s intrinsic value on the settlement date.

Applying the intrinsic value method to stock-based compensation awards classified as equity is

expected to be as rare for nonpublic companies as it is for public companies. A nonpublic company is

unlikely to issue awards with terms so complex and unique that it would be unable to reasonably

determine the awards’ fair value or calculated value.

6.2.1.3 Consistency of measurement method by nonpublic companies

A company should apply the same measurement method for all similar awards, and, for awards that

require periodic remeasurement, over the entire life of each of those awards. If a nonpublic company

used the intrinsic value method for an award and subsequently believes that fair value or calculated

value can be estimated for its new awards, it may use either of those methods, as appropriate, for the

new awards even though it will continue using the intrinsic value method for the old awards. If a

nonpublic entity has previously measured its equity-classified awards at fair value, generally the

company would be unable to justify the use of the intrinsic value or calculated value method for similar

awards in the future as fair value would need to be deemed impracticable. The decision on which

measurement method to use should be based on a company’s specific facts and circumstances.

6.2.2 Measurement of liability awards by nonpublic companies

The alternative measurement methods available to a nonpublic company for measuring its liability-

classified awards depend on the method the company uses to measure its equity-classified awards. A

nonpublic company that uses fair value to measure its equity-classified awards should adopt an

accounting policy to measure all of its liability-classified awards using fair value or intrinsic value. A

nonpublic company that uses a calculated value to measure its equity-classified awards would have an

accounting policy choice to measure all of its liability-classified awards using the calculated value

method or the intrinsic value method. Under each of the measurement alternatives for liability-


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classified awards, the company will remeasure the award on each reporting date using the same

method until the award is settled.

If a nonpublic entity has a policy to measure its liability-classified awards at fair value, generally the

company would be unable to change its policy to use the intrinsic value method, as that change would

likely not be viewed as preferable.

6.2.3 Simplified method for estimating expected term by nonpublics

As discussed in SC 9.3.1, SAB Topic 14 (Section D.2, Question 6) provides a simplified method for

estimating expected term that is not based on a company’s historical exercise data for awards that

qualify as “plain-vanilla” options. It is acceptable for a nonpublic company to use the simplified

method for stock options if they meet the criteria in SAB Topic 14. It may require judgment to

determine whether the criteria are met to apply the simplified method. For example, we believe an

equity-classified option with a repurchase feature that is designed to provide liquidity (e.g., a fair value

repurchase feature) could still be considered “plain vanilla.” However, other repurchase features could

preclude a company from concluding that an option meets the criteria (e.g., certain book value

repurchase features).

6.2.4 Practical expedient -estimating expected term by nonpublics

Nonpublic companies may employ a practical expedient for estimating the expected term of stock-

based compensation awards that would not meet the criteria to apply the simplified method in SAB

Topic 14 (see SC 6.2.3), such as awards with repurchase features and awards with performance

conditions. However, the practical expedient can only be elected if the award meets specified criteria,

which include being granted at the money and not having a market-based vesting condition. The

practical expedient varies based on the vesting conditions, as summarized in Figure SC 6-2.

Figure SC 6-2 Practical expedient for estimating expected term of nonpublic company stock options

Type of vesting provision

Probability of performance condition being met at measurement date

Practical expedient for expected term

Service condition only

(implicit or explicit) N/A Midpoint between the

end of the requisite service period and the contractual term of

award

Service and performance

conditions Probable Midpoint between the

end of the requisite service period and the contractual term of

award

Not probable □ If service period isimplicit: contractualterm

□ If service period isexplicit: midpointbetween the end of


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Type of vesting provision

Probability of performance condition being met at measurement date

Practical expedient for expected term

the requisite service period and the contractual term of award

6.3 Mandatorily redeemable financial instruments

SC 3.3.3 discusses the accounting guidance for public and nonpublic companies that grant awards with

repurchase features including mandatorily redeemable financial instruments. The guidance for most

repurchase features is the same for public and nonpublic companies; however, the guidance on

mandatorily redeemable financial instruments in ASC 480, Distinguishing Liabilities from Equity,

specifically excludes from its scope certain awards issued by companies that are nonpublic companies

that are not SEC registrants or controlled by SEC registrants.

The definition of a nonpublic company is the same under ASC 480 and ASC 718. For example, an

entity with publicly traded debt securities is considered a nonpublic company under ASC 480-10-20

and ASC 718-10-20, but is an SEC registrant and therefore, would not qualify for the scope exclusion.

The scope exclusion in ASC 480 allows equity classification for shares that are required to be

redeemed upon an employee’s termination of service or death at fair value on the redemption date.

However, all other requirements for equity classification in ASC 718 need to be met, including the

requirement that the employee bear the risks and rewards of equity ownership for a reasonable period

of time (i.e., hold the share for at least six months), as discussed in ASC 718-10-25-9. Such instruments

are considered mandatorily redeemable under ASC 480 because termination of services and the death

of the holder are events that are certain to occur. Either a mandatorily redeemable share or an option

that would be settled upon exercise by issuing a mandatorily redeemable share that is subject to the

exclusion, would be classified as equity (assuming that the option meets all other requirements for

equity classification under ASC 718).

For redeemable awards that are accounted for as equity, it may still be necessary to record an amount

outside of permanent equity (i.e., as temporary equity in the mezzanine section of the balance sheet).

See SC 3.3.10. Although the requirements discussed in that section apply to SEC registrants, we

believe non-SEC registrants should follow the same classification treatment.

6.4 Book value plans / formula value plans

A book value or formula value plan is a stock-based compensation plan where the purchase price is

determined by a stated formula based on a company’s current book value, or some other formula.

Some closely held nonpublic companies maintain a book value plan as a way to compensate employees

without giving up voting rights. Most book value plans also require the employee to sell the shares

back to the company after termination at a price determined by the same formula.

A book value plan should be reviewed to determine if (1) awards under the plan are compensatory and

(2) the award’s features, including repurchase features, require the award to be classified as a liability.


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6.4.1 Determining if the book value plan award is compensatory

Employers using book value plans generally issue shares, not options. If an employee acquires shares

under a book value plan on the same terms (including price) available to all other shareholders of the

same class of stock and at the formula price based on the current book or formula value, the

transaction is not compensatory. Essentially, the formula price represents the relevant transaction

price for those shares and the transaction is the sale of a share of stock at that price. Accordingly, no

compensation would be recorded.

To the extent an employee pays less than the then-current formula price to acquire the shares or

receives more than the then-current formula price upon a negotiated repurchase of the shares,

compensation cost should be recorded for the difference. If a company with a book value plan issues

options, compensation cost should be recorded unless the employees pay an amount that is essentially

equivalent to the fair value of the options (based on the formula price for the shares and the terms of

the option).

To obtain noncompensatory accounting treatment for awards issued by a book value plan, the book

value features should apply to all shares within a given class of stock. If there are transactions at a

different price in the same or a similar class of stock, such transactions may establish a value for the

shares at an amount other than the formula price. In these situations, compensation cost should be

recognized for the difference between the price paid by the employee for the shares and the fair value

of the shares.

See ASC 718-10-55-131 through ASC 718-10-55-133 for an example of a book value plan. Fact patterns

that are not consistent with this example likely do not meet the requirements to be accounted for as

noncompensatory.

6.4.2 Determining if the book value plan award is a liability

Awards issued under book value plans need to be assessed to determine whether they include any

features that would require liability classification (refer to SC 3). For example, repurchase features

should be assessed to determine whether the employee bears the risks and rewards of ownership for at

least six months (refer to SC 3.3.3).

Many book value plans have mandatory redemption features that require the shares to be redeemed

upon an employee’s termination of service or death at the then-current formula price. These features

do not preclude equity classification if the company qualifies for the ASC 480 scope exception

discussed in SC 6.3. However, to qualify for equity classification, the employee must bear the risks and

rewards of equity ownership for at least six months. If such an award does not require the employee to

hold the share for at least six months prior to the mandatory redemption, the award would be liability

classified for the period from the grant date (or original purchase date) until six months after vesting.

If the shares within the book value plan are always transacted at the formula price, that price

effectively represents the relevant transaction price for those shares. Thus, a repurchase right with a

price equal to the then-current formula price does not necessarily prevent the employee from bearing

the risks and rewards of equity ownership. However, if there are transactions at a different price in the

same or a similar class of stock, such transactions may establish a value for the shares at an amount

other than the formula price. In these situations, a formula price repurchase right would generally

result in liability accounting.


6-8

6.5 Transition from a nonpublic company to a public company

Once a nonpublic company files an initial prospectus in preparation to sell equity securities, the

company is considered a public company under ASC 718. When that occurs, the company may have to

change some of its accounting policies because of the measurement methods available only to

nonpublic companies (refer to SC 6.2).

6.5.1 Measurement of equity awards when going public

If a nonpublic company was using the calculated value method to measure awards classified as equity,

it will measure all new stock-based compensation awards using the fair value method upon becoming

a public company. The company should continue to recognize stock-based compensation cost using

the calculated value method for awards granted before becoming a public company unless those

awards are subsequently modified, repurchased, or cancelled. If the award is subsequently modified,

repurchased, or cancelled, the event would be assessed under ASC 718’s provisions for a public

company (i.e., at fair value).

6.5.2 Measurement of liability awards when going public

A nonpublic company may need to change the method of measuring awards classified as liabilities

after it becomes a public company. If the nonpublic company had previously chosen to measure its

liability awards using the intrinsic value or calculated value method under ASC 718, it should measure

those same awards at their fair value at the date the company is considered public. If a change in

measurement is made, the effect of the change should be recognized in the period the company

becomes a public company, as discussed in SAB Topic 14 (Section B, Question 2).

For example, assume that on December 31, 20X0, a calendar year company has a vested liability award

that is measured at its intrinsic value of $10. On March 2, 20X1, the company files its initial

prospectus (i.e., becomes a public company as defined by ASC 718) when the award’s intrinsic value is

$13 and its fair value is $15. The company should have recognized compensation cost of $3 between

January 1 and March 2 under the intrinsic value method. Additionally, the company should recognize

$2 of compensation cost to reflect the change from intrinsic value to fair value during the period in

which the company becomes public. The company should remeasure the award to its fair value at the

end of each quarter that the award remains outstanding and record compensation cost for any changes

in fair value in the current period.

SAB Topic 14 does not specify how the adjustment from intrinsic value to fair value should be

presented in the financial statements (i.e., the $2 of compensation cost in this example).

We believe the change from an intrinsic value method to a fair value method is consistent with the

definition of a change in accounting principle as described in ASC 250, Accounting Changes and

Error Corrections. ASC 250-10-45-5 provides for changes in accounting principles to be applied

retrospectively, unless impractical. We believe determining the effects of the change from the intrinsic

to the fair value method would be impractical. Generally, a company would not be able to

independently assess the fair value of the liability awards granted in prior periods; thus, prior periods

should not be adjusted. This is consistent with the guidance in SAB Topic 14 (Section B, Question 3),

which states that a company should not retrospectively apply the fair value method to its awards. As a

result, we believe the incremental compensation costs as a result of a change to the fair value method


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should be recognized either through beginning retained earnings or as compensation cost in the

current period.

6.5.3 Award disclosures when going public

Because a change in measurement method likely results when a nonpublic company becomes public,

SAB Topic 14 requires that a company’s MD&A include the specific changes in accounting policy that

are required under ASC 718 in subsequent periods and the likely future effects.

6.6 Issues regarding cheap stock and IPOs

Registrants who have issued stock, or granted stock options or warrants with exercise prices at a price

significantly below the public offering price (sometimes referred to as “cheap stock”), shortly before

going public, should ensure that they have a sufficient basis to support the valuation of the underlying

stock when issued. The same is true for issuances of convertible preferred stock to vendors, service

providers, or customers shortly before the IPO when the conversion price is below the IPO price and

the registrant recognized the issuance at a fair value significantly below the underlying conversion

value.

For example, a nonpublic company may grant a typical fixed, at-the-money stock option six months

before its IPO. The offering price at the time of the IPO is $10 higher than the option’s exercise price

on the grant date. If, in the six-month period preceding the IPO, there was no discrete event that

increased the fair value of the underlying stock, there is a presumption that the option was a “cheap

stock” grant. This means that, in effect, the company granted an in-the-money stock option. In this

case, the company would have to rerun its option pricing model and record compensation cost to

reflect the higher fair value of the deemed in-the-money option as opposed to the value of the option

when assumed to be at-the-money.

Items affecting the likelihood of an assessment that the company has failed to properly recognize the

compensation cost associated with cheap stock in the period prior to an IPO include:

□ Whether there were any equity or convertible security transactions with third parties for cash

within a reasonable period of time of the grant, and the size and nature of such transactions

□ Appraisals by reputable valuation experts independent of the IPO that were prepared at or near

the grant date

□ Changes in the company’s business that would indicate there has been a change in the value of the

business, such as new contracts or sources of revenues, more profitable operation, etc.

□ The length of time between the grant and the date of the IPO

□ Adequate documentation from the date of the grant or earlier that supports the valuation used by

the company at that time

□ Transfer restrictions

A common misconception is that there is a preconceived range of acceptable discounts from the IPO

price dependent upon the period of time that shares or options were issued prior to the IPO. Each

situation needs to be evaluated based on its own particular facts and circumstances. No arbitrary


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range of discounts should be assumed to be “acceptable.” Any value assigned to stock issued or options

granted (regardless of the extent of discount from IPO price) needs to be supported by relevant market

evidence, not simply a general relationship between the IPO price and the length of time before the

IPO that it was granted.

Evidence should focus on a registrant’s own specific facts and circumstances and not broad industry

factors. Acceptable corroborating evidence often necessitates a credible, independent valuation,

particularly in the absence of proximate similar stock transactions with unrelated parties for cash.

Preferably, the independent valuation should be performed at the time of the stock grant or award.

The AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as

Compensation, provides financial statement preparers, valuation specialists, and auditors (internal

and external) with best practice guidance for valuing privately-held equity securities, including stock-

based compensation awards that are within the scope of ASC 718.

The practice aid also specifies enterprise- and industry-specific attributes that should be factored into

a determination of fair value (e.g., the fair value of stock-based compensation awards that a company

grants to employees), and describes important steps that a company should take when obtaining or

performing a valuation. Finally, the practice aid discusses disclosures companies should consider. See

FSP 15.

Companies should prepare their cheap stock analyses concurrent with the issuance of the related

securities or options and should update them in connection with preparing the IPO registration

statement.

A cheap stock analysis should generally include the following for each equity-related issuance within

the latest fiscal year and interim period through the date of the IPO:

□ The date the security was issued and to whom

□ The deemed fair value of the security, with objective and reliable evidence of how the company

determined the value of such security, including factors that resulted in each change in fair value

during the periods

□ A timeline of events leading up to the filing of the IPO, including discussion and quantification of

the impact on fair value of any company-specific events that occurred between the date the equity-

related awards were granted and the date the registration statement is filed

This analysis should specify the reasons for any difference between the fair value at the transaction

date and the estimated IPO price range.

6.6.1 Escrowed share and similar arrangements

In connection with an IPO or other capital-raising transaction, shareholders (e.g., founders or other

members of management) may agree to place a portion of their shares into escrow to be released back

to them only if specified service or performance-related criteria are met. These arrangements can be

between shareholders and the company or directly between the shareholders and new investors in the

company.


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ASC 718-10-S99 codifies the SEC staff view that escrowed share arrangements are presumed to be

compensatory and equivalent to a reverse stock split followed by the grant of restricted stock.

Accordingly, the company would recognize compensation cost based on the fair value of the shares at

the grant date and recognize that cost over the requisite service period.

This presumption can be overcome in certain fact patterns, particularly if the arrangement is not

contingent upon continued employment. For example, if the escrowed shares will be released or

canceled without regard to continued employment, it may be appropriate to conclude that the

arrangement is in substance an inducement for significant shareholders to facilitate a financing

transaction on behalf of the company. In this situation, the arrangement should be accounted for

based on its substance and reflected as a reduction of the proceeds allocated to the newly-issued

securities. However, if the shares are automatically forfeited if employment terminates, the

arrangement should be accounted for as compensation, consistent with the principle articulated in the

business combinations guidance for contingent payments to employees or selling shareholders (see

ASC 805-10-55-25(a)).

These types of arrangements should generally be reflected in the company’s financial statements even

when the company is not a party to the arrangement (e.g., when the arrangement is between a

shareholder and a new investor). This accounting treatment is consistent with the views in SAB Topic 1

(Section B) and Topic 5 (Section T), and the guidance in ASC 718-10-15-4 regarding share-based

payments awarded to employees by a related party or other holder of economic interest.

In some arrangements, shares are not placed into escrow, but shareholders agree that some portion of

their shares will either be forfeited or can be repurchased for a nominal amount (often the original

purchase price of the shares) upon failure to meet service or performance conditions. These

arrangements are often economically similar to an escrowed share arrangement and, therefore,

generally the same accounting treatment would apply.

6.7 Classification of awards issued by “pass-through” entities

It is often difficult to determine the appropriate classification (liability or equity) of awards granted to

employees of partnerships, limited liability companies (LLCs) and similar pass-through entities.

Awards granted by pass-through entities may be akin to equity interests or profit sharing/bonus

arrangements. This is because the underlying equity on which these awards are granted may contain

rights that differ from other equity instruments of the entity.

There is no authoritative guidance specific to this determination and, therefore, no “bright lines”

between an equity interest versus a “profit sharing” arrangement that is more akin to a bonus (i.e.,

liability). Thus, judgment is required in making that assessment.

The terms of a “profits interest award” in a pass-through entity vary from plan to plan. Depending on

the terms of the award, the interest may be similar to the grant of an equity interest, a stock option, a

stock appreciation right, or a profit-sharing arrangement. A profits interest award should be accounted

for based on its substance.

A profits interest award that is, in substance, a profit-sharing arrangement or performance bonus

would generally not be within the scope of the stock-based compensation guidance (ASC 718) and

would be accounted for under the guidance for deferred compensation plans (ASC 710-10), similar to a


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cash bonus. However, if the award is akin to a performance bonus settled in cash but the amount

payable under the award is based, at least in part, on the price of the company’s shares or other equity

instruments, the arrangement would be accounted for as a liability award in the scope of ASC 718.

If it is determined that an award (or the underlying security) has predominantly equity characteristics

(even if junior to other classes of equity interests), it is subject to the scope of the ASC 718. An

assessment should then be performed to determine whether features of the award result in liability

classification under ASC 718. For example, an award that is equity both in legal form and in substance

might still be liability-classified under ASC 718 due to a repurchase feature based on a formula. Refer

to SC 3.

In many cases, these arrangements will have features that are both similar to equity and liabilities.

Some characteristics should be considered to bear more weight than others, depending on the specific

facts and circumstances of the entity and the arrangement. A key consideration is often understanding

an employee’s rights upon a voluntary termination. If an employee is only entitled to share in profits

while providing employee service and forfeits those rights upon termination of employment, the

arrangement would generally be considered akin to a profit-sharing arrangement or performance

bonus, not an equity award.

Figure SC 6-3 provides a flowchart to determine the appropriate accounting model for awards granted

to employees of pass-through entities.

Figure SC 6-3 Scoping of awards granted to employees of pass-through entities

The following provides a list of the general characteristics to consider when determining whether an

award (or the underlying security) has predominantly equity or liability characteristics. This list is not

all inclusive.


6-13

The following are equity characteristics1 of awards to employees of “pass-through” entities:

□ Legal form of the security is equity

□ Voting rights commensurate with ownership interest

□ Liquidation rights (Rights to net assets of entity on liquidation. Liquidation rights that are

proportionate to other equity holders of a similar class is an equity-like characteristic)

□ Pre-emptive rights (The right of current shareholders to maintain their fractional ownership of a

company by buying a proportional number of shares of any future issue of common stock).

Sometimes may have “drag-along”2 or “tag-along”3 rights which may have “pre-emptive”

characteristics

□ Distributions proportionate to ownership interest. (Instrument participates in the residual returns

of the entity’s net assets in a manner consistent with equity ownership, even if junior to other

classes of equity interests)

□ Rights upon sale of the company commensurate with equity ownership. (Instrument participates

in the same form of consideration, such as stock or debt, received from a buyer as do other equity

holders, rather than receiving cash.)

□ Initial investment required

□ Risk of loss of initial capital (Some arrangements require the employee to “purchase” the equity

interest, subject to certain vesting provisions or repurchase features. If the employee has risk of

loss of this initial investment, it is an equity-like characteristic.)

□ Claims to net assets subordinate to debt holders

□ Interest is transferable after vesting

□ Employee can retain vested interests on termination of service

□ Employee is subject to risks and rewards of equity ownership

□ Management’s intent is to provide the employee an equity ownership interest in the entity

1 If an award (or the underlying security) has predominant characteristics of equity, it is subject to the guidance in ASC 718. However, the award might require liability classification based on the provisions in ASC 718. For example, certain repurchase features could require liability classification despite the fact that the instrument underlying the award has the equity characteristics in this list.

2 A drag-along right grants the controlling shareholder(s) the option to compel shareholders subject to the drag-along provision to sell their shares in a transaction in which the controlling shareholder(s) transfers control of the company, generally under the same terms and in the same proportion. [ASC 805-10-S99.5]

3 A tag-along right grants a shareholder the option to participate in a sale of shares by the controlling shareholder(s), generally under the same terms and in the same proportion. [ASC 805-10-S99.5]


6-14

The following are liability characteristics 4 of awards to employees of “pass-through” entities:

□ Little or no investment required (It is common that no investment is required in stock

compensation arrangements. Thus, it is reasonable that this factor could be outweighed by other

equity characteristics.)

□ Repurchase features (puts/calls) based on a formula (e.g., a fixed multiple of EBITDA)

□ Off-market employer call feature linked to employment (e.g., if an employer can terminate the

employee and call the award at lower than fair value, this is not an equity-like characteristic.)

□ Rights to share in distributions tied to employment (e.g., if employees forfeit their award for no

consideration upon termination, their rights are tied to employment.)

□ Holder entitled to cash upon sale of the company, regardless of the form of consideration paid by

the buyer. (Instrument does not participate in the same form of consideration from the buyer as

do equity holders.)

□ Other cash settlement provisions

□ Creditor-like features (e.g., fixed redemption date)

□ Management’s intent is to provide a performance bonus by allowing employee to share in profits

and distributions of the entity only during employment

□ Profits interest is used in lieu of cash performance bonuses

□ Profits interest used instead of cash bonuses for preferential tax treatment (If cash bonuses were

paid, these would be immediately taxable to the employee as ordinary income. Under profits

interest structure, tax is deferred until realization and taxed at capital gains rates.)

Example SC 6-1 and Example SC 6-2 illustrates the accounting for the grants of profits interest

awards.

EXAMPLE SC 6-1

Grant of profits interest award that is forfeited upon termination

SC LLC grants a profits interest award to its employee. The award vests ratably over a four-year

period. Once vested, the holder is entitled to receive distributions proportionate to their ownership

interest. However, if the employee voluntarily leaves employment or is terminated, the interest is

forfeited for no consideration.

How should SC LLC account for this profits interest award?

4 If an award (or the underlying security) is determined to predominately have characteristics of a liability, generally it is subject to the guidance in ASC 710-10. However, liabilities for which the amount payable is based, at least in part, on the price of the company’s shares or other equity instruments are liability awards in the scope of ASC 718.


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Analysis

In this fact pattern, the profits interest award is akin to a profit-sharing arrangement or performance

bonus, not an equity award. SC LLC should account for the award similar to a cash bonus plan under

ASC 710, accruing cost over the relevant service period when distributions that the holder is entitled to

receive are probable and reasonably estimable. See PEB 6.3. Upon termination, the employee forfeits

all rights to future distributions and receives no consideration for their interest. The holder never

bears the risks and rewards of equity ownership and the amount payable under the award is not based,

even in part, on the price of the entity’s shares or other equity instruments. Therefore, this award is

not a share-based payment in the scope of ASC 718.

EXAMPLE SC 6-2

Grant of profits interest award that can be held beyond termination

SC LLC grants a profits interest award to its employee. The award vests ratably over a four-year

period. Once vested, the holder is entitled to distributions and liquidation and pre-emptive rights

proportionate to their ownership interest, and participates in the same form of consideration as other

equity holders in the event of a sale of the entity. If the employee voluntarily leaves employment or is

terminated without cause, SC LLC has a call option to repurchase the vested interests at fair value on

the repurchase date. SC LLC has the ability to delay the repurchase of the vested interests for at least

six months to allow the employee to bear the risks and rewards of ownership. Unvested interests are

forfeited for no consideration upon termination.

How should SC LLC account for this profits interest award?

Analysis

While all facts and circumstances should be considered, SC LLC would likely conclude that the profits

interest award is a form of share-based compensation under ASC 718. The employee will participate in

future operating and capital transactions of the entity in the same fashion as other equity holders,

proportionate to their interest. Upon termination, the employee can either retain their interest or it

may be repurchased at fair value which, again, is consistent with bearing the risks and rewards of

equity ownership. Therefore, this award is likely a share-based payment in the scope of ASC 718.

The remaining provisions of ASC 718-10-25-6 to ASC 718-10-25-18 should be evaluated to determine

the appropriate classification of the award as equity or liability. If it is determined to be an equity-

classified award, SC LLC should determine the grant date fair value of the profits interest and

recognize it over the requisite service period as described in SC 2.8. If it is determined to be a liability-

classified award, SC LLC should remeasure the award each reporting period at either its fair value or

intrinsic value, depending on its accounting policy for liability-classified awards (as described in SC

6.2.2). In this example, SC LLC would likely determine that the profits interest award is equity-

classified.

When determining the fair value of a profits interest that may be junior to other classes of equity

interests (and might not participate in any distributions or proceeds until the more senior classes have

received specified amounts or specified returns), the potential upside appreciation of the interest must

be considered, similar to an at-the-money stock option. It would generally not be appropriate, for


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example, to value the profits interest based on a hypothetical liquidation of the entity and application

of the distribution “waterfall” as of the grant date.

Chapter 7: Stock-based transactions with nonemployees

Stock-based transactions with nonemployees

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7.1 Stock-based transactions with nonemployees chapter overview

This chapter addresses the accounting for stock-based transactions with nonemployees under ASC 718

upon adoption of ASU 2018-07, Compensation- Stock Compensation (Topic 718) - Improvements to

Nonemployee Share-based Payment accounting (see SC 7.2) and ASU 2019-08, Compensation—

Stock Compensation (Topic 718) and Revenue from Contracts with Customers (Topic 606). See SC

7.2.6 and SC 7.2.7. It also discusses the accounting for stock-based transactions with nonemployees

prior to adoption of ASU 2018-07, under ASC 505-50, Equity—Equity-Based Payments to Non-

Employees. See SC 7.2A. This chapter summarizes the applicable guidance. It does not contain all of

the details included in that guidance and may not address all of the questions that may arise in a given

fact pattern. Balance sheet presentation guidance can be found in FSP 15.

7.2 Accounting under ASC 718, after adoption of ASU 2018-07

This section provides an overview of the accounting for share-based payments to nonemployees

subsequent to adoption of ASU 2018-07 (which amended ASC 718 to also apply to most aspects of

awards issued to nonemployees). We also address the areas where nonemployee accounting continues

to differ from employee share-based payment accounting.

ASU 2018-07 is effective for public business entities for fiscal years beginning after December 15,

2018, including interim periods within that fiscal year. For all other entities, the amendments are

effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years

beginning after December 15, 2020. Early adoption is permitted, but no earlier than an entity’s

adoption of ASC 606. Transition guidance is provided in ASC 718-10-65-11 through ASC 718-10-65-14.

SC 7.2.6 and SC 7.2.7 address the accounting for share-based payments granted to customers upon

adoption of ASU 2019-08. ASU 2019-08 is effective for public business entities, and all other entities

that have early adopted the nonemployee guidance in ASU 2018-07, for fiscal years beginning after

December 15, 2019, including interim periods within those fiscal years. For all other entities that have

not adopted ASU 2018-07, the guidance in ASU 2019-08 is effective for fiscal years beginning after

December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020.

Early adoption, including in interim periods, is permitted in financial statements that have not yet

been issued/made available for issuance, but no earlier than the adoption of the nonemployee

guidance in ASU 2018-07.

An entity that adopts ASU 2019-08 in the same fiscal year as the nonemployee guidance in ASU 2018-

07 should apply the guidance in ASU 2019-08 retrospectively to all prior interim periods in that fiscal

year for which the nonemployee guidance was previously applied. As described in ASC 718-10-65-15, a

cumulative-effect adjustment to retained earnings should be recorded as of the beginning of the fiscal

year of adoption, following the same provisions as in the nonemployee guidance about which

arrangements are subject to the guidance.


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An entity that adopts ASU 2019-08 in a later fiscal year than the nonemployee guidance can either:

□ Apply ASU 2019-08 retrospectively to all prior periods in which the nonemployee guidance has

been previously applied, with a cumulative-effect adjustment to retained earnings as of the

beginning of that year, or

□ Apply the guidance on a modified retrospective basis through a cumulative-effect adjustment to

retained earnings as of the beginning of the fiscal year in which ASU 2019-08 is adopted.

7.2.1 Overview of ASC 718 as amended by ASU 2018-07

Entities will generally apply the same guidance to both employee and nonemployee share-based

awards. However, entities must follow specific guidance for share-based awards to nonemployees

related to the attribution of compensation cost and the inputs to the option-pricing model for expected

term.

7.2.2 Scope of guidance — stock transactions with nonemployees

The FASB limited the scope of ASC 718 to instruments granted for goods or services to be used or

consumed in a grantor’s own operations; it does not apply to instruments issued to provide financing

to the issuer. This was done to address potential structuring concerns. For example, transactions that

otherwise would be accounted for under ASC 815 as a derivative (such as the issuance of an equity-

linked instrument to purchase gold, when the entity does not use the gold in its operations) cannot be

treated as nonemployee awards to purchase products under ASC 718. In this particular example, the

FASB was concerned that an entity could issue such an instrument to purchase a commodity (i.e.,

gold), which could then be sold for cash, effectively resulting in the issuance of an equity-linked

instrument for cash financing.

7.2.3 Measurement of nonemployee awards

Nonemployee share-based payment equity awards are measured at the grant-date fair value of the

equity instruments, similar to employee share-based payment equity awards.

However, in determining the grant-date fair value of options and similar instruments, an entity may

elect to use the contractual term as the expected term in the option-pricing model for its nonemployee

awards. This is because it may be more difficult or even impossible for an entity to determine the

expected term for nonemployee options. The election is available on an award-by-award basis. An

entity may still estimate the expected term as is required for employee awards. An entity should

consider whether it has relevant history for comparable nonemployee awards, which may differ than

the entity’s historical experience for employee awards, and if the terms of the awards are similar.

In addition, a nonpublic entity may also choose to apply a practical expedient in determining the

expected term of nonemployee awards, similar to that available for employee awards, as described in

SC 6.2.4. However, the practical expedient is a policy election and, if elected, must be applied to all

employee and nonemployee awards that meet the following conditions:

□ The award is granted at the money,

□ The grantee has only a limited time to exercise the award (typically 30–90 days) if the grantee no

longer provides goods or terminates service after vesting,


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□ The grantee can only exercise the award (i.e., cannot sell or hedge the award), and

□ The award does not include a market condition.

Certain of these conditions may be less likely to be met for certain types of nonemployee awards and

should be carefully evaluated, such as whether hedging is allowed or if the time to exercise the award is

truncated when service or the supply agreement is terminated. Notwithstanding the policy election

chosen, a nonpublic entity may still elect, on an award-by-award basis, to use the contractual term as

the expected term for nonemployee awards, as indicated above.

ASU 2019-08 clarifies that the practical expedient available for nonpublic entities to estimate the

expected term when valuing share options or similar awards is available for awards granted to

customers. The same conditions described above must be met to apply this practical expedient to

awards issued to customers. In our experience, share-based awards issued to customers do not

typically include a term truncation feature when the counterparty ceases to be a customer. Therefore,

while this practical expedient is technically allowed for share-based awards issued to customers, we

believe its use will be limited. If the practical expedient cannot be utilized, entities may elect to use the

contractual term as the expected term for purposes of measuring the fair value of the award.

Figure SC 7-1 describes the practical expedient for estimating expected term for nonpublic entities.

Figure SC 7-1 Practical expedient for estimating expected term for nonpublic entities

Type of provision Employee awards Nonemployee awards

Service condition only The midpoint between the end of the requisite service period and the contractual term of the award

The midpoint between the end of the vesting period and the contractual term of the award

Performance condition probable of being achieved

The midpoint between the end of the requisite service period and the contractual term

The midpoint between the end of the vesting period and the contractual term

Performance condition not probable of being achieved

If the service period is implied:

□ The contractual term

If the service period is explicit:

□ The midpoint between the end of

the requisite service period and

the contractual term

If the service period is implied:

□ The contractual term

If the service period is explicit:

□ The midpoint between the end

of the vesting period and the

contractual term

The figure reflects that despite the slight differences in the definition of the service period between

employee and nonemployee awards (“requisite service period” vs. “vesting period”), the guidance is

effectively the same.


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If a nonpublic entity has an accounting policy to measure its liability-classified employee share-based

payment awards at intrinsic value, the entity must be consistent and also measure its nonemployee

liability-classified awards at intrinsic value instead of fair value (except those determined to be

consideration payable to a customer, as described in SC 7.2.7.2), and vice versa. If a nonpublic entity

does not already have an accounting policy, then upon adoption of ASU 2018-07, it can make a one-

time election to measure nonemployee liability-classified awards at intrinsic value instead of fair

value. Additionally, nonpublic entities will be able to value nonemployee awards using an industry

sector volatility index (referred to as a “calculated value”) if determination of expected volatility of the

entity’s stock is not practicable, consistent with the guidance for employee share-based payment

awards.

7.2.4 Performance conditions — nonemployee awards

The definition of performance condition in ASC 718 after adoption of ASU 2018-07 is consistent for

employee and nonemployee awards. The accounting for these awards granted to nonemployees

requires using the probability-based recognition approach, consistent with accounting for employee

awards. Refer to SC 2.5.3 for discussion of the accounting model for awards with performance

conditions.

The definition of "performance condition" was clarified by ASU 2018-07 to specifically state that if the

performance condition is in reference to the counterparty's performance, it must be “related to the

grantor's own operations (or activities)" as well as "in accordance with the terms of the award." We

believe that the intent is to ensure that for nonemployee awards, the performance target measures the

impact on the results of the grantor of the goods or services provided by the counterparty in exchange

for the awards. The definition would exclude an award, for example, in which the performance target

was based on the counterparty’s results. Additionally, delivery of goods or services themselves are not

considered “performance conditions” under ASC 718; rather, they are considered “service conditions.”

Performance conditions are limited to a further outcome beyond just delivery, such as the growth in

the issuer’s revenue as a result of marketing services provided by the counterparty.

7.2.5 Attribution of compensation cost for nonemployee awards

Compensation cost for nonemployee awards is recognized in the same period(s) and in the same

manner as if the grantor had paid cash in exchange for the goods or services instead of a share-based

award. This reflects the variety of provisions imposed on nonemployee counterparties in exchange for

the awards, beyond the typical employee services that are provided over time. In many cases,

attribution of compensation cost will be the same as for employee awards. For example, an award

granted to a nonemployee that is earned after 2 years of service as a nonemployee consultant to the

entity generally would be recognized over that 2-year period. However, there may be situations in

which the cost attribution will differ if granted to a nonemployee. For example, if the awards are issued

as payment for goods, the cost may be attributed based on the pattern of delivery of the goods.

The existing policy election of a graded or straight-line basis for attribution of service condition-only

awards with graded vesting only applies to employee awards (see SC 2.8). There is no similar election

for nonemployee awards. As described above, the attribution for nonemployee awards is in the same

manner as if the grantor had paid cash for the goods or services. Therefore, we would anticipate that

entities that had issued nonemployee awards with graded vesting prior to the adoption of ASU 2018-

07 should continue to follow the attribution method they had in place previously. Entities that issue

nonemployee awards with graded vesting for the first time after adoption of ASU 2018-07 should

apply appropriate judgment in determining the attribution of the cost of such awards.


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7.2.6 Awards granted to customers

ASU 2018-07 amends ASC 606, Revenue from contracts with customers, to clarify that consideration

payable to a customer also includes equity instruments (for example, shares, share options, or other

equity instruments). The accounting for the equity instrument (including measurement, classification,

recognition, and disclosure) depends on whether the equity instrument is payment in exchange for a

distinct good or service. Payments to customers in the form of an entity’s own equity instruments in

exchange for a distinct good or service at an amount that does not exceed the fair value of the good or

service are accounted for in accordance with ASC 718, similar to other share-based payments to

nonemployees.

Consideration paid to a customer in the form of equity instruments that is not in exchange for a

distinct good or service is addressed in ASU 2019-08. ASU 2019-08 clarifies that the measurement

and classification of share-based payment awards issued to a customer follows the guidance in ASC

718 for both equity and liability-classified awards. The value determined at the grant date is reflected

as a reduction of the transaction price (and therefore revenue) following the guidance in ASC 606.

As discussed in SC 7.2.5, the guidance for nonemployee share-based payment awards does not specify

when and how to recognize the value of an award, other than to require that an asset or expense (or, in

this case, a reduction of revenue) be recognized in the same period and in the same manner as if the

grantor had paid cash for the goods or services. In accordance with ASC 606-10-32-27, consideration

payable to a customer should be recognized at the later of when the award is promised and when the

entity recognizes revenue for the transfer of the related goods or services. Therefore, for example, if a

share-based payment award issued to a customer vests based on the customer purchasing a specified

number or dollar value of units, the grant-date fair value of the award should be recognized in

proportion to the delivery of the units, which is similar to the accounting for a cash rebate payable

upon the customer achieving a cumulative sales target. See RR 4.6 for further detail.

Example SC 7-1 illustrates the accounting treatment for stock-based compensation granted to a

customer.

EXAMPLE SC 7-1

Accounting by a vendor for stock-based compensation granted to a customer

On January 1, 20X1 Customer agrees to purchase from SC Corporation one widget for $2,000 and SC

Corporation agrees to grant Customer 500 fully vested shares. All of the criteria to establish a grant

date under ASC 718 are met on January 1, 20X1, and the award is classified as an equity instrument

under ASC 718. SC Corporation does not receive any distinct goods or services from Customer as

consideration for the shares. SC Corporation’s share value is $1.00 on January 1, 20X1. SC

Corporation transfers control of the widget to Customer on April 10, 20X1. At that time, SC

Corporation’s share value is $1.50.

How should SC Corporation account for the stock-based compensation granted to its customer?

Analysis

SC Corporation should follow the guidance in ASC 606 for determining the appropriate recognition of

the award. The awards are not a payment for a distinct good or service received from the customer;

therefore, these awards should be considered a reduction of the transaction price (and therefore


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revenue). SC Corporation should follow the guidance in ASC 718 to determine the measurement date

and classification for share-based payment awards granted to Customer. Therefore, these equity-

classified awards should be measured at fair value at the grant date, which is January 1, 20X1.

Jan 1 20X1

Revenue from widgets $ 2,000

Less: Sales incentive 500

Net revenue $ 1,500

This net revenue should be recognized on April 10, 20X1 when control of the widget is transferred to

Customer.

7.2.7 Subsequent measurement of awards granted to customers

ASU 2019-08 clarifies that only the grant-date fair value of share-based payment awards should be

reflected as a reduction in revenue. If the number of equity instruments or their terms can vary based

on achieving a service or performance condition, changes in the expected outcome of those conditions

are reflected in revenue based on the grant-date fair value of those outcomes (see SC 7.2.7.1).

Conversely, any changes in measurement of the share-based awards after the grant date due to the

form of consideration (e.g., a change in the fair value of a liability-classified award) should not be

recognized in revenue, but rather should be recognized elsewhere in the income statement consistent

with the guidance for noncash consideration in ASC 606-10-32-23 (see SC 7.2.7.2).

7.2.7.1 Vesting conditions of awards granted to customers

An award with a service or performance condition may have multiple potential outcomes that affect

the quantity or terms of the award. ASU 2018-07 updated the definition of a service condition to

include a nonemployee delivering goods or rendering services to the grantor over a vesting period,

which would incorporate a vesting condition based upon a customer purchasing a certain quantity or

dollar value of goods or services from the grantor. The definition of a performance condition includes

achieving a target defined solely by reference to the grantor’s own operations (or activities) or the

grantee’s performance related to the grantor’s own operations (or activities), such as an award that

only becomes exercisable upon an IPO of the grantor.

If the number of equity instruments or their terms could change due to a service condition, the entity

should follow its existing accounting policy under ASC 718-10-35-1D for forfeitures of awards issued to

nonemployees (see SC 7.2.10). If the entity’s policy is to recognize the effects of forfeitures of

nonemployee awards only when they occur, the same approach should be applied to awards issued to

customers. In that situation, the transaction price would be reduced for the grant-date fair value of the

full number of equity instruments that could be issued to the customer. If the customer fails to meet

the criteria necessary to earn the award, an adjustment to the transaction price would be made at the

time the award is forfeited to reverse the effects of the forfeited award based on the grant-date fair

value.

If the entity’s policy is to estimate the number of forfeitures expected to occur for awards issued to

nonemployees with service conditions, or if the number of equity instruments or their terms could

change due to a performance condition, the entity should estimate the number of equity instruments

that it will be obligated to issue to the customer each period. Changes in the value of an award when a


7-8

different service or performance outcome becomes probable would be recognized as a change to the

transaction price (as it is not a change in value based on the form of consideration) based on the grant-

date fair value of that new outcome. This estimate would be updated until the award ultimately vests

(or fails to vest).

This is similar to the accounting for share-based payment awards with service or performance

conditions issued to nonemployees for goods or services, other than the classification of the charge

against revenue. It would not be subject to the guidance on measuring variable consideration in ASC

606-10-32-5 through ASC 606-10-32-14.

Market conditions are incorporated into the grant-date fair value of the awards and this amount is

recognized whether or not the market condition is ultimately achieved. This is consistent with the

treatment of awards with market conditions issued to employees or nonemployees for goods or

services.

Example SC 7-2 illustrates the accounting for an equity-classified award with a vesting condition

issued as a sales incentive to a customer.

EXAMPLE SC 7-2

Equity-classified award with a service vesting condition issued as a sales incentive to a customer when

the probability of vesting changes

On January 1, 20X1, Widgetmaker executes a Master Supply Agreement (MSA) with Customer to

deliver widgets with certain specifications. Customer has no minimum purchase requirement. The

MSA has a one-year term. Customer agrees to pay Widgetmaker $1,000 for each widget it orders.

As a sales incentive, Widgetmaker includes terms within the MSA to grant Customer 1,500 fully vested

shares of Widgetmaker if Customer purchases three widgets during 20X1 and remains a customer for

the year. All of the criteria to establish a grant date under ASC 718 are met on January 1, 20X1, and the

award is classified as an equity instrument under ASC 718. Widgetmaker’s accounting policy is to

estimate forfeitures for share-based awards issued to nonemployees.

Upon grant, Widgetmaker believes it is probable that Customer will purchase three widgets in 20X1.

At June 30, due to a downturn in Customer’s business, Widgetmaker believes it is probable that only 2

widgets will be purchased during the year. However, conditions improve in the following quarter and

at September 30, Widgetmaker again believes Customer will purchase three widgets, and ultimately

three widgets are purchased during the year and the shares are earned.

Widgetmaker ’s stock is valued at $1.00 per share on January 1. Widgetmaker’s stock value changed

during 20X1 as follows:

Date Share value

Jan 1 $ 1.00 Mar 31 $ 1.05

Jun 30 $ 1.50

Sept 30 $ 1.00

Dec 31 $ 2.00

During 20X1, Customer issues purchase orders, each for one widget, on March 2, 20X1, June 1, 20X1,

and December 31, 20X1. The widgets are delivered (and control transfers) to Customer on the same

day as each order.


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How should Widgetmaker account for awards issued as a sales incentive to its customer when the

probability of vesting changes?

Analysis

Widgetmaker should look to the guidance in ASC 718 to determine the measurement date for share-

based payment awards granted to Customer. Widgetmaker would measure the fair value of the equity-

classified instruments granted to Customer at the grant date (i.e., January 1, 20X1, when they are

worth $1.00 per instrument), which is when the parties reached a mutual understanding of the key

terms and conditions of the award. While the ultimate value of the award can change based on

Customer’s actions in this case, changes due to revisions in the expected outcome of a service or

performance condition are not deemed to be changes due to the form of the consideration and,

therefore, should be reflected in the transaction price.

ASC 718 provides guidance for when to recognize nonemployee share-based payments. Nonemployee

awards should be recognized in the same period and manner as if the grantor had paid cash instead of

issuing a share-based award.

Consistent with the guidance in ASC 606-10-32-27, assuming that revenue is recognized at a point in

time for the sale of widgets, Widgetmaker should recognize the grant-date fair value of the awards

($1,500 in total: 1,500 shares x $1.00/share) as a reduction of revenue as control of the widgets is

transferred to Customer, if the vesting condition is considered probable of achievement. In this

example, since the $1,500 value of the equity awards is specifically associated with the delivery of

three widgets, it would be appropriate to ascribe $500 of that value to each widget delivered. If

revenue was recognized over time (such as for services provided continuously over the period), then

the grant-date fair value of the awards would be recognized as a reduction of revenue over time.

Widgetmaker’s accounting is summarized as follows:

Date Cumulative revenue

recognized Probability assessment of

Customer earning award

Cumulative amount

recorded as a reduction

of revenue

Jan 1 no accounting

Mar 31 $1,000 (1 widget) Yes $1,500 × 1/3 = $500

Jun 30 $2,000 (2 widgets) No, only 2 widgets anticipated $01

Sept 30 $2,000 (2 widgets) Yes $1,500 × 2/3 = $1,0002

Dec 31 $3,000 (3 widgets) Yes $1,500

1 As vesting of the award is no longer considered probable at June 30, Widgetmaker’s best estimate is that it will not issue any shares to Customer. Therefore, the amount recognized as a reduction of revenue in the March 31 quarter ($500) for the share-based payment award should be reversed in the June 30 quarter. This results in a net increase in revenue for the quarter.

2 As vesting of the award is again considered probable at September 30, Widgetmaker’s best estimate is that it will issue the 1,500 shares to Customer. As two of the three required widgets have been purchased as of September 30, two-thirds of the original grant date fair value of $1,500 should be recognized as a cumulative reduction of revenue at that date. Therefore, $1,000 would be recognized as a reduction of cumulative revenue to Customer in the September 30 quarter for the share-based payment award, even though no sales revenue to Customer was recognized in the quarter.


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7.2.7.2 Liability-classified awards granted to customers

ASU 2019-08 clarifies that changes to the fair value of a share-based award issued to a customer after

the grant date due to the form of consideration (i.e., market value changes) would not be recognized as

part of the transaction price. This is consistent with the guidance for noncash consideration in ASC

606-10-32-23. For example, if the award is classified as a liability and is being marked-to-market each

period, only the fair value determined as of the grant date would be recorded as a reduction of

revenue. Subsequent changes to the instrument’s fair value each period would be reflected elsewhere

in the income statement. This may follow, for example, the entity’s treatment of gains and losses on

derivative financial instruments under ASC 815, although the guidance does not prescribe a treatment.

ASU 2019-08 requires nonpublic entities to measure both equity-classified and liability-classified

awards that are determined to be consideration payable to a customer at fair value. Furthermore, any

subsequent measurement of liability-classified awards issued to customers must also be measured at

fair value. This is required even for nonpublic entities that have elected a policy to measure their

liability-classified awards issued in exchange for goods or services at intrinsic value.

Example SC 7-3 illustrates the accounting for a liability-classified share-based payment award issued

as a sales incentive to a customer.

EXAMPLE SC 7-3

Liability-classified award issued as a sales incentive to a customer

On January 1, 20X1, Widgetmaker executes a Master Supply Agreement (MSA) with Customer to

deliver widgets with certain specifications. Customer has no minimum purchase requirement. The

MSA has a one-year term. Customer agrees to pay Widgetmaker $1,000 for each widget it orders.

As a sales incentive, Widgetmaker includes terms within the MSA to grant Customer 1,500 fully vested

cash-settled stock appreciation rights (SARs) of Widgetmaker if Customer purchases three widgets

during 20X1. All of the criteria to establish a grant date under ASC 718 are met on January 1, 20X1,

and the award is classified as a liability instrument under ASC 718. Widgetmaker’s accounting policy is

to estimate forfeitures for share-based awards issued to nonemployees. Throughout the year,

Widgetmaker believes that it is probable that Customer will purchase the three widgets, and Customer

ultimately does so.

The fair value of a SAR measured on January 1 is $1.00. The fair value of each SAR changed during

20X1 as follows:

Date Fair value

Jan 1 $ 1.00

Mar 31 $ 1.05

Jun 30 $ 1.50

Sept 30 $ 1.00

Dec 31 $ 2.00

During 20X1, Customer issues purchase orders, each for one widget, on March 2, 20X1, June 1, 20X1,


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and December 31, 20X1. The widgets are delivered (and control transfers) to Customer on the same

day as each order.

How should Widgetmaker account for liability-classified awards issued as a sales incentive to its

customer?

Analysis

Widgetmaker should look to the guidance in ASC 718 to determine the measurement date for share-

based payment awards granted to Customer. Widgetmaker would measure the fair value of the

liability-classified instruments granted to Customer at the grant date (i.e., January 1, 20X1, when they

are worth $1.00 per instrument), which is when the parties reached a mutual understanding of the key

terms and conditions of the award, to determine the amount that should be reflected as a reduction in

the transaction price of the revenue contract. Changes in the measurement of the share-based

payment award after the grant date that are due to the form of the consideration (i.e., due to the

classification of the award as a liability) are reflected elsewhere in the income statement and not as an

adjustment to revenue.

ASC 718 provides guidance for when to recognize nonemployee share-based payments. Nonemployee

awards should be recognized in the same period and manner as if the grantor had paid cash instead of

issuing a share-based award.

Consistent with the guidance in ASC 606-10-32-27, assuming that revenue is recognized at a point in

time for the sale of widgets, Widgetmaker should recognize the grant-date fair value of the awards

($1,500 in total: 1,500 SAR’s x $1.00/SAR) as a reduction of revenue as control of the widgets is

transferred to Customer, if the vesting condition is considered probable of achievement. In this

example, since the $1,500 value of the share-based awards is specifically associated with the delivery

of three widgets, it would be appropriate to ascribe $500 of that value to each widget delivered. If

revenue was recognized over time (such as for services provided continuously over the period), then

the grant-date fair value of the awards would be recognized as a reduction of revenue over time. Even

though the fair value of the liability-classified awards must be remeasured each period, there is no

change in the amount charged against revenue. The impact of the mark-to-market accounting for the

awards issued to Customer is recorded on another line in Widgetmaker’s income statement.

Similar to the accounting for liability awards issued to nonemployees to acquire goods or services, the

liability as of each reporting period should reflect the percentage of the aggregate current fair value of

the share-based payment award that would have been recognized had the entity paid cash instead of

issuing the award. In this example, one-third of the total value of the award is associated with each

widget. Therefore, based on how many widgets have been delivered to Customer at each reporting

date, Widgetmaker would record a liability equal to the proportionate amount of the aggregate then-

current fair value of the entire 1,500 SAR’s. The difference between this amount and the proportion of

the grant-date fair value recorded against revenue is the amount to record elsewhere in Widgetmaker’s

income statement.


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Widgetmaker’s accounting is summarized as follows:

Date SAR

value Mark-to-market

liability

Recorded as

reduction of

revenue at

grant date

fair value as

each widget

is delivered

Cumulative amount

recorded as a

reduction of

revenue

Cumulative

amount

recorded

outside of

revenue

Amount

recorded

outside of

revenue in

the quarter

1/1 $ 1.00 no accounting

3/31 $ 1.05 $525

(1,500×$1.05*1/3)

$500 $500

(1 widget delivered)

$25 $25

6/30 $ 1.50 $1,500

(1,500×$1.50*2/3)

$500 $1,000

(2 widgets delivered)

$500 $475

9/30 $ 1.00 $1,000

(1,500×$1.00*2/3)

$1,000


$0 $(500)

12/31 $ 2.00 $3,000

(1,500×$2.00*3/3)

$500 $1,500


$1,500 $1,500

7.2.7.3 Modifications and settlements of awards to customers

ASC 718 provides guidance on modifications and settlements of awards issued in exchange for goods

or services, focusing on incremental value provided to the counterparty (see SC 4.2 and SC 4.8). ASU

2019-08 does not explicitly address modifications and settlements of awards issued to a customer,

other than in the context of potentially transitioning to other guidance. Consistent with the overall

approach in ASU 2019-08 to measure and classify share-based payment awards issued to customers

under ASC 718 and then account for the resulting amounts under ASC 606, we believe the guidance in

ASC 718 should be used to measure the impact of a modification or settlement of a share-based

payment award issued to a customer. That is, companies should compare the fair value of the award

immediately before and immediately after the modification or settlement to determine if the change

creates any incremental value to the holder. Any incremental value would then be considered a further

payment to the customer under ASC 606.

The recognition of the incremental value will depend on the facts and circumstances and what aspect

of the revenue contract modification model is applicable under ASC 606. For example, the incremental

value of the share-based award may simply be accounted for as an immediate additional charge to

revenue if the associated goods and services have already been fully delivered and the modification is

not associated with the execution of a new contract. However, if the goods and services are still being

delivered, the incremental payment to the customer may be viewed as a contract modification subject

to the guidance in ASC 606-10-25-10 to ASC 606-10-25-13. Based on that guidance, for example, the

incremental value associated with the share-based payment award (a change in the transaction price)


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may lead to accounting for the transaction as the cancellation of the existing contract and the creation

of a new contract. See further discussion of revenue contract modifications in RR 2.9.

7.2.7.4 Awards to customers becoming subject to other guidance

ASU 2019-08 clarifies that a share-based award issued to a grantee will continue to be accounted for

under the share-based payment guidance in ASC 718 throughout the life of the award, unless its terms

are modified after a grantee:

□ vests in the award and is no longer providing goods or services,

□ vests in the award and is no longer a customer, or

□ is no longer an employee.

7.2.7.5

If the terms are modified after one of these situations (other than in certain qualifying equity

restructuring transactions), the modification is accounted for under the share-based payment

guidance, but after the modification, the recognition and measurement of the instrument is subject to

other applicable GAAP (see SC 4.10). For example, if a stock option issued to a customer is modified

after the counterparty ceases to be a customer, the modification would first be subject to the guidance

in ASC 718, and then immediately after the modification, the stock option would be subject to the

classification and measurement guidance in ASC 815, Derivatives and Hedging. ASU 2019-08 does

not specify when a counterparty ceases to be a “customer.” For example, it is unclear how to consider a

counterparty that has fulfilled its existing contract but is in negotiations for a potential new contract.

Appropriate judgment should be applied based on the facts and circumstances.

Goods/services given to customers before the grant date

ASU 2019-08 clarifies that equity instruments granted by an entity in conjunction with selling goods

or services should be measured and classified at the grant date, as that date is defined in ASC 718.

However, there may be circumstances when goods or services are delivered to a customer before the

grant date of an associated share-based award; for example, if the terms and conditions of the award

have not yet been finalized at the time goods or services begin to be delivered, or if the exercise price of

an option will be set based on a future stock price. In such a circumstance, the award should be

measured at its fair value as of the reporting dates that occur before the grant date, and that amount

should be reflected in the determination of the transaction price each period in accordance with the

guidance on variable consideration in ASC 606-10-32-7 and ASC 606-10-32-27. That amount should

be updated (on a cumulative effect basis) each subsequent reporting period until the grant date occurs.

Once the grant date occurs, the entity should adjust the transaction price for the cumulative effect of

measuring the fair value at the grant date rather than the fair value previously used.

7.2.8 Awards to employees/nonemployees of equity method investees

ASC 323-10-25-3 through ASC 323-10-25-6 requires that, for transactions in which stock-based

compensation is incurred by an investor on behalf of an equity method investee, the investee should

apply the guidance in ASC 718 to measure compensation expense incurred by the investor on its behalf

and record a corresponding capital contribution. The investor should recognize an expense for the

portion of the costs incurred that benefits other investors and recognize the remaining cost as an

increase to its equity investment in the same period compensation expense is recognized on the books

of the investee.


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The investor shall recognize the full cost of the awards as incurred (that is, in the same period the costs

are recognized by the investee) for share-based payment awards granted to employees or

nonemployees of an equity method investee (that provide goods or services to the investee that are

used or consumed in the investee’s operations). This is assuming no proportionate funding by the

other investors occurs and the investor does not receive any increase in the investor’s relative

ownership percentage of the investee. Therefore, awards to nonemployees of an equity method

investee will be measured at the grant date fair value and recognized as if cash had been paid for the

goods or services.

Other non-contributing investors should recognize income equal to the amount that their interest in

the investee’s net book value has increased. In ASC 323-10-S99-4 the SEC Observer indicated that SEC

registrant investors should classify any expense or income resulting from the application of this

guidance in the same income statement caption as the equity in earnings (or losses) of the investee.

ASC 323-10-25 does not apply to situations in which proportionate funding exists. In these cases, both

investors are contributing stock-based awards (or other consideration) of proportionate value. Because

of the proportional contributions, a cash contribution to the investee would be an equity investment to

the investor. Similarly, ASC 323-10-25 does not apply to arrangements established at the time of the

investor’s original investment in the investee. When the compensation expense is recorded on the

investee’s books, the investor would record a portion of the expense in relation to the equity

investment.

We understand, based on discussions with the FASB staff, that this guidance is limited to grants of

investor share-based payment awards to employees and nonemployee service providers of equity

method investees. This does not extend to awards issued to employees and nonemployee service

providers of entities under common control. Refer to SC 1.6 for further details.

7.2.9 Awards in the form of convertible instruments

Entities occasionally issue convertible instruments (such as debt or preferred stock that is convertible

into common stock of the entity) to nonemployees in exchange for goods or services. The fair value of

the instrument at the grant date will be used to measure compensation cost.

ASU 2020-06, Debt - Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives

and Hedging - Contracts in Entity’s Own Equity (Subtopic 815-40), eliminates the beneficial

conversion and cash conversion accounting models for convertible instruments. See FG 6.7.

ASU 2020-06 is effective for public business entities that meet the definition of an SEC filer, excluding

entities eligible to be smaller reporting companies as defined by the SEC, for fiscal years beginning

after December 15, 2021, including interim periods within those fiscal years. For all other entities, the

amendments are effective for fiscal years beginning after December 15, 2023, including interim

periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning

after December 15, 2020, including interim periods within those fiscal years. The ASU must be

adopted as of the beginning of an entity’s fiscal year and may not be adopted in an interim period.

7.2.9.1 Convertible instruments, after adoption of ASU 2020-06

The grant-date fair value of convertible instruments (such as debt or preferred stock that is convertible into common stock of the entity) issued to nonemployees in exchange for goods or services will be used to measure compensation cost. These share-based payment awards in the form of convertible

https://www.pwc.com/us/en/cfodirect/publications/accounting-guides/guide-to-accounting-for-stock-based-compensation-2013-edition.html


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instruments will remain subject to the recognition and measurement guidance of ASC 718 throughout the life of the instrument (and will not be reassessed under other applicable GAAP, such as ASC 815, Derivatives and hedging, or ASC 470-20, Debt – Debt with conversion and other options), unless the terms of the award are modified after the grantee vests in the award and is no longer providing goods or services (or is no longer an employee or customer).

7.2.9.1A Convertible instruments, prior to adoption of ASU 2020-06

The fair value of convertible instruments (such as debt or preferred stock that is convertible into

common stock of the entity) issued to nonemployees in exchange for goods or services will be used to

measure compensation cost and to determine if there is an initial beneficial conversion feature to

record as of the grant date. Additionally, the fair value of the convertible instrument and the related

intrinsic value of the conversion option (using the fair value of the underlying common stock) is

required to be remeasured at the date the award becomes fully vested for purposes of determining if a

beneficial conversion feature exists at that date. See FG 6.7 for further information on beneficial

conversion features.

The post-vesting treatment of employee and nonemployee awards is consistent and generally does not require assessing the instruments issued to nonemployees under other applicable literature once performance is complete. However, an award that is convertible into equity instruments of the grantor follows the recognition and measurement requirements of other applicable literature upon vesting (including ASC 470-20, Debt - Debt with conversion and other options).

7.2.10 Forfeiture policy election

Existing guidance in ASC 718 allows an entity to establish an accounting policy for employee awards to

either estimate forfeitures or account for them when they occur. See SC 2.7 for further discussion on

the accounting policy for forfeitures. An entity must also establish a forfeiture policy for nonemployee

awards. The policy for nonemployee awards can be the same or different as the policy for employee

awards; however, these policies must be applied consistently to their respective types of awards.

7.2A Accounting under ASC 505-50 prior to adoption of ASU 2018-

7.2.1A

07

ASC 505-50-30 requires all nonemployee transactions, in which goods or services are the

consideration received in exchange for equity instruments, to be accounted for based on the fair value

of the consideration received or the fair value of the equity instruments issued, whichever is more

reliably measurable. In situations where an SEC registrant is applying this guidance, the fair value of

the equity instruments should be used. We believe this should generally also be the case for nonpublic

companies. This section provides an overview of ASC 505-50, including the measurement and period

and manner of recognition for stock-based transactions with nonemployees.

Overview of ASC 505-50 prior to adopting ASU 2018-07

Prior to the amendments in ASU 2018-07, ASC 718 did not prescribe the measurement date or provide

guidance on recognition for transactions with nonemployees. ASC 505-50 addresses the measurement

date and recognition approach for such transactions. ASC 505-50 does not, however, apply to the

following transactions:

□ Transactions with individuals meeting the definition of an employee.


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□ Transactions with employee stock ownership plans.

□ Transactions involving equity instruments either issued to a lender or investor that provides

financing to the issuer or issued as consideration in a business combination.

See SC 1.5 for guidance on the definition of an employee.

7.2.2A Measurement date and performance commitment -ASC 505-50

ASC 505-50 states that the fair value of an equity instrument issued to a nonemployee (i.e.,

counterparty) should be measured by using the stock price and other measurement assumptions as of

the earlier of the date at which either: (1) a commitment for performance by the counterparty has been

reached; or (2) the counterparty’s performance is complete.

A performance commitment is defined as a commitment under which performance by the

counterparty to earn the equity instruments is probable because of sufficiently large disincentives for

nonperformance. This disincentive must result from the relationship between the issuer and the

counterparty, beyond the equity instruments themselves. Question SC 7-1A addresses the assessment

an entity should perform to determine whether a performance commitment contains a “sufficiently

large disincentive for nonperformance.”

Question SC 7-1A

How should an entity assess whether a performance commitment contains a “sufficiently large

disincentive for nonperformance”?

PwC response

The assessment of whether a performance commitment contains a “sufficiently large disincentive for

nonperformance” should be based on both quantitative and qualitative factors. Generally, we believe

situations in which “performance commitments” exist prior to performance being completed will be

rare.

With respect to assessing if there exists a performance commitment, the guidance notes that forfeiture

of the equity instrument as the sole remedy for nonperformance by the counterparty would not be

considered a sufficiently large disincentive for nonperformance.

In addition, the ability to sue for nonperformance, in and of itself, does not present a sufficiently large

disincentive to ensure that performance is probable. The guidance discusses that an entity can always

sue for nonperformance but that it is not always clear if any significant damages would result. We

believe that since ASC 505-50 specifically indicates that the mere ability to sue for damages is not

considered a sufficiently large disincentive for nonperformance, there must be specific delineation of

the potential penalties if the counterparty does not perform as specified in the contract.

The penalties (i.e., large disincentives for nonperformance) should be assessed against the value of the

arrangement, not just the value of the equity award. In addition to these factors, other factors to

consider may include, but are not limited to, the following:

□ Whether the counterparty would be able to pay the damages.

□ Whether the penalty is financially significant to the counterparty.


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□ Whether the counterparty would be negatively impacted by its nonperformance (i.e., the

counterparty may provide unique services to the issuer that may lead to future services).

□ Whether there are other arrangements the counterparty may have with the issuer that may be

impacted by nonperformance.

□ Whether the overall size and profitability of the arrangement is such that the penalty could be

recouped through other, more profitable, work.

The assessment of whether there is a counterparty performance commitment should be made at the

time of grant; no reassessment is needed as the arrangement progresses.

If no performance commitment has been reached by the time the counterparty completes its

performance, the issuer should ultimately measure the fair value of the equity instruments at the date

the counterparty’s performance is complete. The counterparty’s performance is complete when the

counterparty has delivered or, in the case of sales incentives, purchased the goods or services.

Typically, the date the counterparty’s performance is complete is also the date the equity instruments

vest, because at that date, no further service or other action is required for the counterparty to receive

the equity instruments. As noted in SC 7.2.3A, if there is an intervening service period between the

initial grant of the award and the performance completion date, interim determinations of fair value

should be utilized.

ASC 505-50-25-7 discusses situations in which counterparty performance may be required over a

period of time but the equity award granted to the party performing the services is fully vested,

exercisable, and nonforfeitable on the date the parties enter into the contract. The measurement date

for such an award would generally be the date the parties enter into the contract, even though services

have not yet been performed, because the counterparty’s ability to exercise and benefit from the award

is not contingent upon performing the services.

7.2.3A Period and manner of recognition under ASC 505-50

ASC 505-50 generally does not address the period(s) or the manner (that is, capitalize versus expense)

in which SC Corporation should recognize the fair value of the equity instruments that will be issued.

However, the guidance indicates that an asset, expense, or sales discount should be recognized in the

same period and in the same manner as if SC Corporation paid cash to a vendor in exchange for goods

or services, or paid cash to a customer as a sales incentive or discount.

Similar to the accounting for employee options, a recognized asset, expense, or sales discount should

not be reversed if an award expires unexercised for which the counterparty has completed its

performance and for which all the terms have been established.

The quantity and terms of the equity instruments may be known upfront. If this is the case and if it is

appropriate under GAAP for the issuer to recognize any cost of the transaction during financial

reporting periods before the measurement date, the equity instruments are measured at their then-

current fair values at each of those financial reporting dates (i.e., the instruments are “marked-to-

market” through the measurement date).

SC 7.2.4A through SC 7.2.5A discuss the accounting for awards if the quantity or terms of the equity

instruments are not known upfront.


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7.2.4A Variability before/on the measurement date -ASC 505-50

The quantity and/or terms of equity instruments may not be known upfront because they depend on

counterparty performance conditions or market conditions. If the quantity and/or terms depend on

either performance conditions or both performance and market conditions, and cost is recorded prior

to the measurement date, the equity instruments should be measured at their then-current lowest

aggregate fair value at each financial reporting date (i.e., the lowest amount at which the award may be

earned if the conditions are not achieved). This amount may be zero.

Similarly, on the measurement date, if the quantity or any of the terms of the equity instruments

depend on achieving counterparty performance conditions (or both performance and market

conditions) that, based on the different possible outcomes, result in a range of aggregate fair values for

the equity instruments as of that date, the issuer should utilize the lowest aggregate amount within

that range for recognition purposes.

The examples in ASC 505-50-55-28 through ASC 505-50-55-40 illustrate the application of this

guidance.

Question SC 7-2A addresses the application of ASC 505-50 to determine if a counterparty performance

condition exists.

Question SC 7-2A

If the number of equity awards to be received by a counterparty is determined based on the level at

which the counterparty performs and performance is substantially within the counterparty’s control,

does a counterparty performance condition exist?

PwC response

No, we do not believe that a counterparty performance condition exists, as defined in ASC 505-50.

For example, a nonemployee counterparty will receive 100 equity awards if it purchases 10,000 units

of a particular product from the issuer (vendor). In this scenario, the counterparty can control the

outcome (i.e., how many units it will purchase) and ultimately determine how many equity awards it

will receive (similar to a service condition). We believe that this type of condition is not a counterparty

performance condition as contemplated by ASC 505-50, and it would therefore not be appropriate to

apply the “lowest aggregate fair value” guidance in ASC 505-50. In this arrangement, recognition of

the then-current fair value of the equity awards prior to the measurement date should be assessed

based on the probability that the counterparty will perform.

Conversely, if the event that determines the number of equity awards to be received by the

counterparty is outside of the control of the counterparty, then the “lowest aggregate fair value”

guidance in ASC 505-50 would apply. For example, a nonemployee counterparty will receive 100

equity awards if it resells 10,000 units of the issuer’s (vendor’s) product to end-user customers. In this

scenario, the counterparty cannot typically control the number of units it will sell because the ability to

sell the units depends on outside factors, including the level of customer demand. In this arrangement,

the amount of cost recognized should be based on the lowest aggregate fair value, which may be zero,

in periods prior to reaching the sales target. The issuer would not assess the probability that the

performance condition will be achieved.


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The accounting treatment of an award with a performance condition that is granted to a nonemployee

differs from the guidance for awards granted to employees. For awards granted to employees, a

probability assessment is generally made for all performance conditions. For awards granted to

nonemployees, if performance is outside the control of the counterparty, the cost recognized may be

zero (if zero is the lowest aggregate fair value) prior to the achievement of the performance condition,

even if the issuer believes it is probable the performance condition will ultimately be achieved.

7.2.5A Variability upon a market condition under ASC 505-50

If the quantity or terms of an equity instrument depend only on market conditions, cost should be

measured based on the then-current fair value of the equity instruments. ASC 505 describes an

approach to calculate the fair value based on the fair value of the equity instruments without regard to

the market condition plus the fair value of the issuer’s commitment to change the quantity or terms of

the equity instruments if the market condition is met. In other words, the fair value of the equity

instruments should incorporate the market condition, similar to an employee award.

On the measurement date, the then-current fair value of the equity instrument should be determined,

incorporating the market condition. Subsequent to the measurement date, the issuer should recognize

and classify any future changes in the fair value (including the market condition) in accordance with

the relevant accounting literature on financial instruments (e.g., ASC 815-40). ASC 505-50-55-14

illustrates the application of this guidance.

7.2.6A Changes after the measurement date under ASC 505-50

In some situations, the quantity and/or terms of an equity instrument may not be known until a point

in time after the measurement date. After the measurement date, revisions in the quantity or terms of

equity instruments should generally be recorded using modification accounting similar to ASC 718-20-

35. The adjustment should be measured at the date of the revision of the terms of the equity

instruments as the difference between (1) the then-current fair value of the modified award utilizing

the then-known quantity and/or terms and (2) the then-current fair value of the original award

immediately before the quantity and/or terms become known.

For transactions that involve only performance conditions, the then-current fair value is calculated

using the assumptions that result in the lowest aggregate fair value if the quantity and/or any terms

remain unknown. The example in ASC 505-50-55-22 through ASC 505-50-55-24 illustrates the

application of this guidance.

For transactions that involve both performance and market conditions, modification accounting

should be applied, as described above, for the resolution of both performance and market conditions,

through the date the last performance condition is resolved. If, at the date the last performance-related

condition is resolved, any market conditions remain, the issuer should measure the then-current fair

value of the commitment related to the market condition. This amount is an additional cost of the

transaction. Thereafter, the issuer should, to the extent necessary, recognize and classify future

changes in the fair value of this commitment related to the market condition in accordance with the

relevant accounting literature on financial instruments (e.g., ASC 815-40). The example in ASC 505-

50-55-15 through ASC 505-50-55-16 illustrates the application of this guidance.


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7.2.7A Awards to equity method investee’s employees -ASC 505-50

ASC 323-10-25-3 through ASC 323-10-25-6 requires an investee to apply the guidance in ASC 505-50

to measure compensation cost incurred by an investor on its behalf and to record a corresponding

capital contribution. The investor should recognize an expense for the portion of the costs incurred

that benefits other investors and recognize the remaining cost as an increase to its equity investment

in the same period that compensation cost is recognized on the books of the investee.

Other non-contributing investors should recognize income equal to the amount that their interest in

the investee’s net book value has increased. In ASC 323-10-S99-4 the SEC observer to the EITF

indicated that SEC registrant investors should classify any expense or income resulting from the

application of this guidance in the same income statement caption as the equity in earnings (or losses)

of the investee. The example in ASC 323-10-55-19 through ASC 323-10-55-26 illustrates this guidance.

ASC 323-10-25 does not apply to situations in which proportionate funding exists. In these cases, both

investors are contributing stock-based awards (or other consideration) of proportionate value.

Similarly, ASC 323-10-25 does not apply to arrangements established at the time of the investor’s

original investment in the investee. When the compensation cost for these arrangements is recorded

on the investee’s books, the investor would record the portion of the cost related to the equity

investment as part of its ongoing equity in earnings accounting under the equity method.

Example SC 7-1A illustrates an investor’s accounting treatment for stock-based compensation granted

to employees of an equity method investee that would not be in the scope of the guidance in ASC 323-

10-25-3 through ASC 323-10-25-6.

EXAMPLE SC 7-1A

Accounting by an investor for stock-based compensation granted to employees of an equity method

investee

SC Corporation enters into an arrangement with Third Party Corporation (an unrelated third party) to

form a joint venture. SC Corporation will contribute a subsidiary (which includes employees) to the

venture and will receive a 50% interest, which will be accounted for under the equity method (the

"investee").

Investee employees will be allowed to retain stock options in SC Corporation that were granted prior to

the formation of the venture. Such awards will continue to vest based on the employees' service for the

venture. Upon the exercise of the stock options, Third Party Corporation will pay to SC Corporation, in

cash, its proportionate share (i.e. 50%) of the book compensation expense recorded on the investee's

financial statements.

How should SC Corporation account for the cash received from Third Party Corporation for the

options exercised subsequent to the formation of the joint venture?

Analysis

ASC 323-10-25 addresses the accounting for stock-based compensation awards of the investor's stock

granted to employees of an investee accounted for under the equity method, when no proportionate

funding by the other investor occurs and the investor does not receive any increase in its relative

ownership percentage of the investee. Further, ASC 323-10-25 assumes that the investor's grant of


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stock-based compensation to employees of the equity method investee was not agreed to in connection

with the investor's original acquisition of its interest in the investee.

SC Corporation's fact pattern differs from ASC 323-10-25 because Third Party Corporation is funding

its economic share of the award, and the arrangement was part of the original formation of the

venture. However, this guidance provides a useful frame of reference for SC Corporation's situation.

The value recognized over the vesting period for the options is measured under ASC 505-50 because

the individuals are no longer considered employees of SC Corporation and is initially treated as an

addition to the investment account in the investee on SC Corporation's books.

Going forward, 50% (its proportionate share) of the investment on SC Corporation's books attributable

to the contributed options will be absorbed by the pick-up of a proportionate share of the stock-based

compensation cost recorded by the venture, which will be measured and recorded by the venture with

a corresponding capital contribution. To the extent the stock options are subsequently exercised by

employees of the venture, Third Party Corporation will have an obligation to make cash payments to

SC Corporation for 50% (its proportionate share) of the book compensation expense of the awards

recognized by the venture. Such amounts received by SC Corporation would be recorded as a reduction

of the remaining portion of the investment account that had been established when the awards were

originally contributed to the venture.

7.2.8A

7.2.9A

Accounting for awards given to a customer under ASC 505-50

In many arrangements, the issuer may be selling goods or services, issuing equity awards (e.g.,

warrants), and receiving cash payments from the nonemployee counterparty. We believe that in

arrangements where a fixed amount of equity awards are issued to a nonemployee counterparty (i.e., a

customer), in addition to providing the counterparty goods or services, and the counterparty is also

paying a contractually required amount of cash to the issuer, the payments received from the

counterparty should first be considered payment for the equity awards. In other words, the fair value

of the equity awards (remeasured each period through the measurement date or the final

determination of the terms of awards with counterparty performance conditions) should be

considered a reduction of revenue (sales discount). Any cash in excess of the fair value of the equity

awards should generally be considered revenue.

Equity awards issued to suppliers, customers or other providers may take various forms. ASC 605-50,

as well as ASC 606-10-32-25 and RR 4.6, provide further guidance on the accounting for consideration

given to a customer, which applies whether the payment is made in cash or in the form of equity

instruments.

Accounting when ASC 505-50 does not address a topic

In SAB Topic 14, the SEC staff noted that not every potential nonemployee transaction is addressed by

ASC 505-50 and that when specific guidance does not exist, registrants should generally apply the

principles contained in ASC 718 to nonemployee transactions, unless the application of this guidance

would be inconsistent with the terms of the nonemployee transaction. For example, in footnote 7 of

SAB Topic 14 the SEC staff noted that it would generally not be appropriate to use an expected term

assumption shorter than the contractual term when estimating the fair value of an instrument issued

to a nonemployee if certain features, including nontransferability, non-hedgeability, and the

truncation of the contractual term, are not present in the nonemployee award.


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ASC 505 and ASC 718 do not provide specific guidance on accounting for liability-classified awards

issued to nonemployees; however, we generally believe that such awards should be accounted for at

fair value each period through settlement, consistent with the overall measurement principles of ASC

718. We also believe that under certain facts and circumstances, it may be appropriate to estimate

forfeitures in accounting for both liability and equity awards granted to nonemployees.

7.2.10A Classification of awards to nonemployees under ASC 505-50

Consistent with the discussion in SC 7.2.9A, while there is no explicit guidance in ASC 505-50, we

believe the classification of awards issued to nonemployees, although within the scope of ASC 505-50,

would generally be the same as awards issued to employees. See SC 3 for discussion of features that

cause an award to be liability-classified.

7.2.11A Accounting after performance is complete under ASC 505-50

As discussed in SC 4.10, ASC 718-10-35 provides that an award originally granted as employee

compensation will generally remain subject to ASC 718 for the life of the award. This guidance does

not apply to equity instruments granted to nonemployees prior to adoption of ASU 2018-07.

Nonemployee awards cease being subject to ASC 505-50 after the counterparty’s performance is

complete and, from that point forward, become subject to other applicable GAAP (e.g., ASC 480,

Distinguishing Liabilities from Equity or ASC 815, Derivatives and Hedging). Depending on their

terms, that guidance could require accounting for such instruments as liabilities. Refer to FG 5.5 and

DH 2.

For example, assume a company grants a fully vested, nonforfeitable warrant to a nonemployee in

exchange for services. The measurement date of the warrant is the grant date because no future

performance is required by the holder to retain the warrant. However, because performance has been

completed as of the grant date, the company would also need to assess the accounting for the warrant

under other applicable GAAP, including ASC 480 and ASC 815.

7.2.12A Illustration: nonemployee stock option award - ASC 505-50

Example SC 7-2A illustrates the application of ASC 505-50 to an award of stock options to a

nonemployee that cliff vests. The quantity and terms of the equity instrument are known up front, and

there is no performance commitment.

Tax implications have not been included in this example, refer to TX 17.

EXAMPLE SC 7-2A

Nonemployee stock option award that cliff vests at the end of a period

SC Corporation enters into an arrangement with an independent contractor to provide service. The

contractor will be compensated by earning 1,000 non-qualified stock options with an exercise price of

$30 and an exercise period of 10 years that cliff vest at the end of four years provided that service is

rendered through that date. If the contractor does not complete the service, the award is forfeited. This

transaction does not contain a performance commitment because the contractor has no disincentive

for nonperformance other than the loss of stock options. The contractor commences work on January

1, 20X1 and completes service at the end of four years.


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On December 31, 20X5, the contractor exercises all 1,000 options, when the market price of SC

Corporation’s common stock is $100 per share.

How should SC Corporation record the associated compensation expense in each reporting period over

the service period and upon the subsequent exercise of the stock options?

Analysis

A measurement date, as defined in ASC 505-50-30, does not occur until the end of the fourth year. The

stock options should be revalued each period and measured at their then-current fair value at the end

of each period, with a final measurement taking place at the end of the fourth year when performance

is complete and the options are earned.

The following schedule presents the fair value per option and associated compensation expense at

each reporting period over the service period. For illustrative purposes, only year-end reporting is

shown; however, SC Corporation would also be required to perform interim reporting following a

similar methodology.

Reporting period

Fair value

per option

Number of options

Aggregate fair value

Percentage of services

rendered

Cumulative compensation

cost

Compensation cost previously

recognized

Current period compensation cost (benefit)

1/1/20X1 $10 1,000 $10,000 0% $0 $0 $0

12/31/20X1 $15 1,000 $15,000 25% $ 3,750 $0 $ 3,750

12/31/20X2 $30 1,000 $30,000 50% $15,000 $ 3,750 $11,250

12/31/20X3 $35 1,000 $35,000 75% $26,250 $15,000 $11,250

12/31/20X4 $25 1,000 $25,000 100% $25,000 $26,250 $(1,250)












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Dr. Additional paid-in capital $1,250

Cr. Compensation expense $1,250

To recognize compensation expense (benefit) in 20X4

On December 31, 20X4 when the contractor completes the service, the stock options vest. The award

would be measured at its then-current fair value and would no longer be adjusted. Assume that SC

Corporation evaluated the award under ASC 815-40 (as described in SC 7.2.11A) and determined that

equity classification continued to be appropriate.

Upon exercise, SC Corporation would record the following entry.

Dr. Cash $30,000



To recognize the exercise of 1,000 options at an exercise price of $30; the par value of the common

stock is $0.01

In Example SC 7-2A, the award cliff vests, and therefore the entire award is marked to market each

period until the measurement date is reached. Example SC 7-3A illustrates an instance in which the

award vests in tranches over time as the service is provided.

EXAMPLE SC 7-3A

Nonemployee stock option award that vests in tranches

SC Corporation enters into an arrangement with an independent contractor to provide service. The

contractor will be compensated by earning 1,000 non-qualified stock options with an exercise price of

$30 and an exercise period of 10 years. 250 options vest at the end of each year over four years in

conjunction with the contractor continuing to provide service through those dates. If the contractor

does not complete the service, only the awards associated with the uncompleted service are forfeited.

How should SC Corporation record compensation expense at each reporting period over the service

period?

Analysis

A measurement date, as defined in ASC 505-50-30, for each tranche of options would occur at the end

of each year when the work associated with that year was completed and the corresponding options

vest. The fair value of the vested awards is fixed as of the vesting date. Unvested awards would

continue to be marked to market until the relevant vesting date of each tranche. SC Corporation would

record compensation expense on a straight-line basis over the service period, which is the same

manner as if they had paid cash instead of share-based awards.


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Assume the following fair value of each tranche:

Tranche Vesting date Fair value per option Number of options

in tranche Fair value of

options in tranche

1 12/31/X1 $15 250 $3,750

2 12/31/X2 $30 250 $7,500

3 12/31/X3 $35 250 $8,750

4 12/31/X4 $25 250 $6,250

The following schedule presents the fair value per option and an approach to record the associated

compensation expense at each reporting period over the service period. For illustrative purposes, only

year-end reporting is shown; however, SC Corporation would also be required to perform interim

reporting following a similar methodology.

Reporting period

Fair value

per option

Number of options

Aggregate fair value

(1)

Percentage of services

rendered

Cumulative compensation

cost

Compensation cost previously

recognized

Current period compensation

cost

12/31/X1 $15 1,000 $15,000 25% $3,750 $0 $3,750

12/31/X2 $30 1,000 $26,250 50% $13,125 $3,750 $9,375

12/31/X3 $35 1,000 $28,750 75% $21,562 $13,125 $8,437

12/31/X4 $25 1,000 $26,250 100% $26,250 $21,562 $4,688

(1) The following schedule shows the calculation of the aggregate fair value of the options for each

reporting period.

Tranche Number of

options

20X1 Calculation of aggregate fair

value


value


value


value

1 250 250 × $15 = $3,750

(2) 250 × $15 = $3,750

(2) 250 × $15 = $3,750

(2) 250 × $15 = $3,750

(2)

2 250 250 × $15 = $3,750

(3) 250 × $30 = $7,500

(2) 250 × $30 = $7,500

(2) 250 × $30 = $7,500

(2)

3 250 250 × $15 = $3,750

(3) 250 × $30 = $7,500

(3) 250 × $35 = $8,750

(2) 250 × $35 = $8,750

(2)

4 250 250 × $15 = $3,750

(3) 250 × $30 = $7,500

(3) 250 × $35 = $8,750

(3) 250 × $25 = $6,250

(2)

Total $15,000 $26,250 $28,750 $26,250

(2) Vested tranche—fixed value at vesting date

(3) Unvested tranche—then-current fair value


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Chapter 8: Estimating fair value using option-pricing models

Estimating fair value using option-pricing models

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8.1 Estimating fair value using option-pricing models overview

Because observable market prices are generally not available for employee stock options, companies

will need to use an option-pricing (or equity valuation) model to estimate the fair value of employee

stock options and other employee equity awards, such as restricted stock with market conditions. The

best known valuation techniques are the Black-Scholes-Merton (Black-Scholes) model, Monte Carlo

simulation models, and lattice (or binomial) models.

This chapter discusses the considerations involved in selecting an option-pricing or equity valuation

model, the theoretical underpinnings of the Black-Scholes, Monte Carlo, and lattice models, and how

to apply the models when estimating the fair value of employee stock options or other equity awards.

While the choice between the Black-Scholes, Monte Carlo simulation, and lattice models is important,

the fair value estimates produced by any of these techniques are largely dependent upon the

assumptions used. The assumptions usually have a greater impact on fair value than the choice of

model. Developing assumptions for use in an option-pricing or equity valuation model is discussed in

SC 9.

8.2 Selecting an option-pricing model

ASC 718-10-55-11 permits companies to select the option-pricing or equity valuation model that best

fits their unique circumstances as long as the valuation technique:

□ is applied in a manner consistent with the fair value measurement objectives and other

requirements of ASC 718,

□ is based upon established principles of financial theory, and

□ reflects all of the substantive terms and conditions of the award.

As a result, for most employee stock options and other employee equity instruments, companies will

have flexibility in selecting the option-pricing or equity valuation model used to estimate the fair value

of their stock-based compensation awards.

The Black-Scholes model is relatively simple to use and well understood in the financial community.

Its relative simplicity stems, in part, from the fact that when estimating the fair value of an employee

option, all expected employee exercise behavior and post-vesting cancellation activity is reduced to a

single average expected term assumption.

The principal advantage of lattice models, on the other hand, is that they can accommodate a wider

range of assumptions about employees’ future exercise patterns, as well as accommodate other

assumptions that may change over time. This approach may yield a more refined estimate of fair value.

A Monte Carlo model simulates a very large number (as many as 1,000,000) of potential stock price

scenarios over time and incorporates varied assumptions about volatility and exercise behavior for

those various scenarios. A fair value is determined for each potential outcome. The grant date fair

value of the award is the average of the fair values calculated for each potential outcome.


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For awards with typical service conditions and performance conditions, the Black-Scholes model will

generally produce a reasonable estimate of fair value. Monte Carlo simulation and lattice models result

in a more refined estimate of fair value. Additionally, companies that issue awards with market

conditions or payoff conditions that limit exercisability should use either a Monte Carlo simulation

model or a lattice model because those models can better incorporate assumptions about exercisability

in relation to the price movements of the underlying stock and/or potential payoff outcomes related to

achievement of market conditions.

Companies will need to weigh the advantages and disadvantages of each model in order to choose a

model that fits their particular circumstances. In deciding which model is most appropriate, some

factors to consider are:

□ Compensation plan design: The specific terms of awards granted by a company may have an

impact on which option-pricing or equity valuation model it selects. For example, it is generally

appropriate (and common practice) for most “plain vanilla” stock options to be valued using the

Black-Scholes model. However, lattice models are sometimes used for other awards, including

options that are in-the-money, awards with market conditions, and awards with payoff functions

limited in certain ways (such as maximum value options, as discussed in SC 10.3). Furthermore, it

is common practice for a Monte Carlo simulation model to be used when valuing awards

containing a market condition.

□ Data availability: The principal advantage offered by Monte Carlo simulation and lattice models

is that they can accommodate a wider range of assumptions; however, this poses certain

challenges. Companies may need to analyze a significant amount of detailed historical employee

exercise behavior in order to develop appropriate assumptions required by a lattice model or a

Monte Carlo simulation model. Many companies may not have the necessary historical data, or

may conclude that their history is not relevant in making assumptions about future exercise

patterns. Thus, the Black-Scholes model may be more practical, assuming it is appropriate for the

type of award. Additionally, SAB Topic 14 provides a simplified approach, subject to certain

conditions, for developing an expected term assumption for “plain vanilla” options, making the

continued use of the Black-Scholes model significantly less difficult and time consuming. ASC 718-

10-30-20A through ASC 718-10-30-20B provides a similar option for nonpublic companies.

□ Cost-benefit analysis: Although the Monte Carlo simulation and lattice models may provide a

more refined estimate of fair value for some award types, companies should weigh the costs

involved before switching from the Black-Scholes model. Some companies may determine that the

costs of applying a Monte Carlo simulation or lattice model outweigh the benefits of a more

refined fair value estimate.

Companies may decide to change from one option-pricing or equity valuation model to a different one

(e.g., from Black-Scholes to a lattice model). A change in option-pricing model is not a change in

accounting principle—the underlying objective of estimating the fair value of the award is the same—

and therefore does not require justification of preferability (or a preferability letter in the case of an

SEC registrant). However, changes in valuation models should generally only be made when the new

model will result in an improved estimate of fair value. Additionally, companies may use one model for

certain awards and another model for different types of awards. For example, the fair value of a “plain

vanilla” option could be estimated using the Black-Scholes model while a Monte Carlo simulation is

used for an option with a market condition.


8-4

SAB Topic 14 requires companies to disclose any changes to the option-pricing model they use and the

reasons for the change. Because Monte Carlo simulations and lattice models are generally considered

to provide more refined estimates of fair value than the Black-Scholes model, we believe that once a

company adopts a Monte Carlo simulation or lattice model to value a particular type of award,

although this is not a change in policy that would require preferability, it would likely be difficult to

support switching back to the Black-Scholes model to value that same type of award.

8.3 The financial theory behind option-pricing models

The Black-Scholes, Monte Carlo simulation and lattice models all stem from the same financial

concepts: (a) that a portfolio can be built that exactly replicates the payoff on an option or equity

instrument at each point along the time spectrum that extends from the award’s grant date through its

expected term and (b) that the fair value of risky financial instruments can be modeled in a risk-

neutral framework. Each of these valuation techniques uses many of the same variables (assumptions)

to estimate an award’s fair value. These include the exercise price (if applicable), an expected term, the

price of the underlying stock, the stock’s expected volatility, the risk-free interest rate, and the

dividend yield over the award’s expected term.

The Black-Scholes model reduces all expected employee exercise behavior and post-vesting

cancellation activity to a single average expected term assumption. Lattice models replace this single

assumption with a more complex set of assumptions. Thus, lattice models can accommodate a wider

range of assumptions about employees’ future exercise patterns than the Black-Scholes model, as well

as assumptions that may change over time. These additional assumptions should yield a more refined

estimate of fair value.

Lattice and Monte Carlo simulation models can accommodate a wide range of employee exercise

behavior as well. In addition, when valuing equity awards other than options, the primary advantage

of Monte Carlo simulation or lattice models is that they can accommodate a much wider variety of

award terms and provisions than the Black-Scholes model.

8.4 The Black-Scholes model

A cornerstone of modern financial theory, the Black-Scholes model was originally a formula for

valuing options on stocks that do not pay dividends. It was quickly adapted to cover options on

dividend-paying stocks. Over the years, the model has been adapted to value more complex options

and derivatives. For example, a modified Black-Scholes model could be used to value an option with

an exercise price that moves in relation to a stock index.

To estimate an option’s fair value using the Black-Scholes model, it is first necessary to develop

assumptions at the measurement date (generally the grant date). See SC 2.6.1 and SC 9 for

information about the grant date and developing assumptions, respectively). The six key variables are:

□ Per share market price of the underlying stock

□ Exercise price of the option

□ Expected term of the option

□ Risk-free interest rate for the duration of the option’s expected term


8-5

□ Expected annual dividend yield on the underlying stock

□ Expected stock price volatility over the option’s expected term

The stock price is simply the quoted market price for publicly-traded securities or the estimated fair

value of a share of stock for a private company on the measurement date. The exercise price is

generally defined by the terms of the award. Developing the valuation model inputs (assumptions) for

the remaining four variables requires judgment.

As described in ASC 718-10-55-27, the assumptions used to estimate an award’s fair value should be

determined in a consistent manner. For example, if an entity uses the closing share price or the share

price at another specified time as the current share price on the grant date in estimating fair value,

that technique should be employed consistently from period to period for all awards.

Figure SC 8-1 summarizes the manner in which each assumption impacts the value of an option.

Figure SC 8-1 Impact of Black-Scholes assumptions on fair value

Assumptions

Impact on option’s fair value as

assumption/input increases

Impact on option’s fair value

Less significant

More significant

Stock price Increase X

Exercise price Decrease* X

Expected term Increase X

Expected volatility Increase X

Expected dividend yield Decrease X**

Risk-free interest rate Increase X

* Assuming an at-the-money option, a higher exercise price (and stock price) would drive a higher option fair value, purely as a result of the higher time value component of the option value. For an in-the-money option, holding the stock price constant, the exercise price will have an inverse relationship on the intrinsic value of the option—i.e., a higher strike price would reduce the option’s fair value.

** For a large change in dividend yield (e.g., a change from 3% to 6%) this assumption can become more significant.

We note that that Figure SC 8-1 represents high-level general trends that ignore the potential

interactions between assumptions. For example, in certain cases, a longer expected term assumption

may decrease the fair value of an award that is significantly in the money if a high dividend yield is

assumed.

8.4.1 Expected term of an option

The Black-Scholes model uses a single input for an option’s expected term (the weighted average

expected term)—the anticipated time period between the measurement date (typically the grant date)

and the exercise date or post-vesting cancellation date—to estimate the fair value of an employee stock


8-6

option. The expected term falls between the option’s vesting and contractual expiration dates. It can

never be less than the period from the grant date to the vesting date. However, as employees may

exercise options at widely varying times, developing the expected term assumption is highly

judgmental.

SAB Topic 14 provides SEC registrants with a simplified method to calculate the expected term

assumption for “plain vanilla” options when the company has no relevant exercise experience on

which to develop their assumption. ASC 718-10-30-20A through ASC 718-10-30-20B provide a similar

simplified method for nonpublic companies. If a company cannot apply this simplified method, it

should develop its expected term assumption by analyzing its employees’ past exercise patterns for

similar options. See SC 9.3.1 for information on the simplified method for developing the expected

term assumption and the factors to be considered by companies that do not use the simplified method.

An option’s expected term can have a significant effect on its fair value. Figure SC 8-2 shows how

varying expected term assumptions affect the fair value of options issued by a typical emerging

company and by a mature company. A change in the expected term assumption will have a greater

impact on an option’s fair value if the option has a shorter expected term. In contrast, the impact tends

to flatten out for longer expected terms. When there is less volatility in the price of the underlying

stock (as is the case for the mature company), the fair value of options is lower for all possible expected

terms as compared to options for a stock with higher volatility. The fair value is also more linear in

relation to expected term.

Figure SC 8-2 Sensitivity of sample fair value to expected term input

8.4.2 Expected volatility of an option

Stock price volatility is another key input in all option-pricing models. ASC 718-10-20 defines volatility

as “a measure of the amount by which a … price has fluctuated … or is expected to fluctuate … during a

period,” and also as “a probability-weighted measure of the dispersion of returns about the mean.” In


8-7

mathematical terms, in the context of the Black-Scholes model, volatility is the annualized standard

deviation of the natural logarithms of periodic stock price changes over the option’s expected term. In

other words, volatility is a statistical measurement of a stock’s relative propensity towards wide price

movements over a given time and reflects the expected variability of the returns on a company’s stock.

The price of a less volatile stock fluctuates over a smaller range than does the price of a more volatile

stock.

Volatility has a significant impact on the fair value of a stock option. Because a more volatile stock has

greater upside potential (and greater downside risk) as a percentage of the stock price than a less

volatile one, an option on a stock with high volatility has greater value than an option on a stock with

low volatility, assuming all other assumptions are equal. The volatility assumption reflects the benefit

of an option holder’s right to participate in the upside potential (i.e., stock price increases) with less

exposure to downside risk (i.e., stock price decreases). While a number of factors can affect a stock’s

expected volatility, in general terms, a more mature company is likely to exhibit lower share price

volatility than an emerging or high growth company.

Option values are sensitive to changes in volatility assumptions. Figure SC 8-3 illustrates the

sensitivity of fair value to stock price volatility for an emerging and a mature company with different

expected term assumptions. The fair values for the mature company are higher than for the emerging

company because the mature company has a longer expected term. However, the effect of the longer

expected term would typically be offset to some degree by a lower volatility assumption for the mature

company. For example, the fair values of options for the two companies shown in Figure SC 8-3 would

be equivalent (about $50) if the expected volatilities of the emerging company and the mature

company were approximately 73% and 53%, respectively.

Figure SC 8-3 Sensitivity of sample fair value to volatility input


8-8

8.4.3 Risk-free interest rate for options

The use of an interest rate in valuing an option reflects the time value of the exercise price for the

period (the expected term) over which the option holder is able to defer the cash outlay of the exercise

price. Management must determine the expected term of an option before it can select the risk-free

interest rate because the interest rate must correspond to the duration of the option. ASC 718 requires

that the assumed risk-free interest rate be based on the yield on the measurement date of a zero-

coupon instrument, such as US Treasury STRIPS, with a remaining duration to maturity equal to the

award’s expected term. The higher the interest rate, the higher the fair value of the option.

8.4.4 Dividend yield of an option

Since the market price of a stock reflects, in theory, the value of all future dividends expected to be

paid, the dividend yield assumption serves to reduce the value of an option for the dividends that will

be paid prior to the point at which the option holder becomes a shareholder entitled to participate in

dividends. Under ASC 718, the dividend yield assumption usually reflects a company’s historical

dividend yield (i.e., average annualized dividend payments divided by the stock price on the dates

recent dividends were declared) adjusted for management’s expectations that future dividend yields

might differ from recent ones. The dividend yield assumption represents the expected average annual

dividend payment over the life of the award. Because option or other award holders typically do not

receive dividend payments prior to exercise or vesting, a higher dividend yield assumption will reduce

the fair value of an award if all other assumptions and conditions of the award are equal. For awards

when the holder is entitled to receive dividends prior to exercise or vesting, a 0% dividend yield is

generally appropriate. See SC 9.6.3 for more details.

8.4.5 Black-Scholes model: Underlying theory

As noted earlier, the Black-Scholes model is based on the theory that a replicating portfolio can be

built that exactly reproduces the payoff of an option based on certain assumptions. The replicating

portfolio does this through a combination of shares of stock and risk-free bonds. The fair value of an

option can be computed in terms of (1) the price of the underlying stock (or short positions in the

stock) and (2) the price of a zero-coupon bond of the appropriate maturity (or short position on the

bond), so long as the balance of long and short positions can continually be adjusted to exactly match

the option’s payoffs upon expiration.

Describing how the Black-Scholes model allocates the components of the replicating portfolio involves

advanced financial theory and mathematics that are beyond the scope of this guide. Because some

knowledge of the underlying theory may be helpful in understanding what drives an option’s fair

value, the following pages present an overview of two basic components of an option’s fair value:

intrinsic value and time value. Time value is itself subdivided into two further sub-components:

minimum value and volatility value.

8.4.6 Intrinsic value of an option

The first component of the fair value of an employee stock option is intrinsic value. It is the value, if

any, at any given date that an employee could realize if the option were exercised (i.e., the amount by

which the underlying stock’s market price is greater than the option’s exercise price). The intrinsic

value for a vested and unvested option is the same, even though an unvested option cannot actually be

exercised until it is vested.


8-9

On the grant date, the intrinsic value of most employee stock options issued by US companies is zero

because the exercise price typically equals the price of the underlying stock. Such options are said to be

issued at-the-money. An option with a positive intrinsic value is said to be in-the-money, while one

where the exercise price exceeds the underlying stock price has no intrinsic value and is said to be

underwater or out-of-the-money.

Options have different risks from those of the shares underlying them. The risk of loss is always lower

for an option-holder than a shareholder because an option-holder cannot sustain a loss greater than

the value of the option—which is always worth less than the value of the underlying stock—while a

stockholder can lose the entire price paid for or current fair value of the shares. As a result, option-

holders enjoy the same opportunities for gain as a shareholder, but with less risk of loss.

8.4.7 Time value of an option

The second component of the fair value of an employee stock option is time value. This component is

comprised of two sub-components: minimum value and volatility value.

8.4.7.1 Minimum value of an option

Minimum value is dependent upon the underlying stock price at grant date, the exercise price, the

time to expected exercise, the expected dividend payments on the underlying stock during the option’s

life, and the risk-free interest rate.

Computing an option’s minimum value does not require any particular assumptions about the

movement of the underlying stock (i.e., expected volatility); in fact, the only significant judgment

required is an estimate of the option’s expected term. Additionally, judgments regarding the

appropriate risk-free interest rate and dividend yield should be made, but these assumptions usually

have a much smaller impact on the estimate of minimum value. Minimum value at grant date is the

current value of company stock minus the net present value of funds that will be used in exercising the

option, and is calculated by subtracting from the current stock price, the present value (using the risk-

free interest rate) of both the exercise price and any dividend payments expected during the option’s

expected term. In essence, minimum value—which is usually substantially lower than fair value—

represents that portion of an option’s fair value that is not contingent on volatility, but rather just

reflects the benefit of the time value of not having to pay the exercise price until a later date while still

enjoying any appreciation of the stock price that may occur. Figure SC 8-4 illustrates the calculation of

minimum value.

Figure SC 8-4 Illustration of minimum-value calculation

Assumptions:

□ Expected term—6 years

□ Exercise price—$50

□ Stock price on grant date—$50

□ Expected annual dividend yield—1% (annually compounded)

□ Risk-free interest rate—3% (continuously compounded)


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Minimum value computation:

Current stock price $50.00

Less:

□ Present value of exercise price ($50 discounted at 3% over 6 years) 41.76

□ Present value of expected dividends (at 1% over 6 years) 2.90

Minimum value $5.34

8.4.7.2 Volatility value of an option

Under ASC 718, stock price volatility is considered when calculating an option’s fair value.

In the Black-Scholes model, an option’s fair value will equal its minimum value when volatility is

assumed to be zero, or a number very close to zero. Many software versions of the Black-Scholes model

will not allow an input of zero volatility, so a very small value (e.g., 0.001%) may be used as the

volatility input to demonstrate this equivalence. The volatility assumption should reflect the degree of

uncertainty about possible future returns (price changes) on the underlying stock. Volatility value

relates to an option’s unlimited upside potential and the limited downside risk of principal loss

compared with the risk of holding the underlying stock.

Under the mathematical formula underlying the Black-Scholes model, as the value of the volatility

assumption increases, the fair value of the option increases since a higher volatility raises the potential

payoff. For example, if volatility was assumed to be 20%, 50%, and 80% for the option illustrated in

Figure SC 8-4, the estimated fair value under the Black-Scholes model would be $11.52, $23.17, and

$32.59, respectively.

Due to the time value and volatility value of an option, the fair value of an option is always higher than

the option's intrinsic value. Even an out-of-the-money option (which has $0 intrinsic value) generally

has some amount of fair value as there is a possibility of upside if the stock price appreciates without

the risk of further downside loss if the stock price declines. However, fair value begins to converge

with intrinsic value as the option approaches its expiration date, as well as for deep-in-the-money

options.

8.5 Lattice models

Lattice models can accommodate a broader array of inputs with respect to employee exercise patterns,

as well as volatility, dividend, and interest rate assumptions, over the option’s contractual term.

Because of their flexibility, the financial community has long used lattice models for valuing options

and other equity instruments. For example, a trader valuing an option that expires in three months

might enter a single value for each of the six assumptions used in the Black-Scholes model. Using a

lattice model, the same trader could enter a dynamic forecast with different volatility estimates for

different sub-periods (e.g., days or weeks) of the option’s three-month life. By incorporating the

additional information from this dynamic forecast versus the single average volatility forecast that is

input into the Black-Scholes model, the trader attempts to arrive at a more precise value for the

option.


8-11

In a similar manner, lattice models can incorporate far more detailed assumptions about employees’

future exercise patterns than the Black-Scholes model. The Black-Scholes model reduces all possible

employee exercise patterns to a weighted-average that is used as a single input—the expected term—

while lattice models can incorporate a range of inputs describing possible exercise behavior. A simple

lattice model might incorporate an array of values for each of the four inputs related to employee

exercise behavior:

□ Contractual term of the option – the maximum period for which the option can be held

□ Vesting period – the shortest period until the option can be exercised

□ Exercise multiple – also known as the suboptimal exercise factor, the exercise multiple is an

assumption about “early exercise” behavior or patterns based on stock-price appreciation rather

than the time that has elapsed since the grant date. It is described as the expected ratio of stock

price to exercise price at the time of exercise. Early exercise refers to the exercise of an option prior

to the end of the contractual term.

□ Post-vesting termination rate – the likelihood that an employee will be compelled to make an

exercise decision prior to the conclusion of the option’s contractual term

A more complex lattice model could incorporate considerably more information. Generally, lattice

models incorporate the full contractual term of an option, and not simply the expected period until

the option is settled (as in the Black-Scholes model).

For these reasons, ASC 718-10-55-17 through ASC 718-10-55-18 recognize that, in many cases, lattice

models may provide a more accurate value of employee stock options than the Black-Scholes model.

However, while a company might be able to calculate a slightly more refined value using a lattice

model, it may not be worth the extra effort to achieve only a slightly different result. Therefore, very

few companies currently use a lattice model to value “plain vanilla” at-the-money stock options. For

those options, a Black-Scholes model is typically used. However, for companies valuing in-the-money

options (such as those assumed in a business combination) that do not otherwise have a market

condition, use of a lattice model may be justified. As noted in SC 8.2, awards with market conditions or

payoff conditions that limit exercisability typically are valued using a lattice model or Monte Carlo

simulation (refer to SC 8.6).

Companies considering using a lattice model often engage an outside consultant to develop the model

and analyze the necessary assumptions. Even when a valuation consultant is engaged, it is important

for management to understand the valuation methodology and ensure the assumptions used in the

model and the results of the valuation comply with the requirements of ASC 718 and SAB Topic 14.

In addition to the various assumptions that can be input into a lattice model, several different

mathematical types of lattice model exist, including the binomial model, the trinomial model, finite-

difference methods, and other versions of the lattice approach. There is also a related approach

involving randomly generated simulated stock-price paths through a lattice-type structure called a

Monte Carlo simulation. This section of the guide focuses on the binomial model, the simplest of these

approaches, and we touch on Monte Carlo models in the next section. The binomial model

accommodates a large number of potential future price points for the underlying stock over the

option’s contractual term, which can be varied depending upon the number of price points necessary

to accurately simulate the real distribution of the stock’s potential market prices.


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8.5.1 A highly simplified binomial model

To better understand how binomial models work, consider the assumptions in Figure SC 8-5 regarding

a stock option grant.

Figure SC 8-5 Stock option grant


Exercise price $100

Vesting period (cliff vesting) 3 years


Expected term 6 years




The Black-Scholes model using the assumptions in Figure SC 8-5 yields an estimated fair value of

$35.29. Employee early exercise patterns, post-vesting cancellations, and the other factors affecting

the expected term assumption are reflected only indirectly in the expected term of six years.

Regardless of expected stock price fluctuations, the Black-Scholes model assumes all option-holders

will exercise their options six years after the grant date. It does not consider the full distribution of

potential exercise times, which in this case, range from three years (the vesting date) to ten years (the

contractual term), nor does it consider any possible correlation between stock price appreciation and

the likelihood that employees will exercise their options (exercise multiple).

The first step in the application of the binomial model entails calculating the possible terminal values

of the option (i.e., the possible intrinsic values at the end of its contractual term). This binomial model

calculates a number of potential future stock prices based on the volatility and risk-free interest rate

assumptions. Figure SC 8-6 illustrates this by assuming the stock price moves in discrete one-year

intervals over the option’s 10-year contractual life (one-year intervals were used for simplicity). A

lattice model would normally use smaller time-steps and thus would encompass a smoother

distribution of potential stock prices over many more possible values.

Binomial lattice models require two computations, called “binomial tree-diagrams,” in order to value a

stock option. Figure SC 8-6 illustrates the first tree-diagram, in which the stock price begins at $100

(stock price on grant date) and increases or decreases according to certain assumptions over the ten-

year period of the option’s contractual life. Figure SC 8-7, Figure SC 8-8, Figure SC 8-9, and Figure SC

8-10 illustrate different versions of tree-diagrams, in which the option value is calculated backwards from possible option-values on the settlement date to the theoretical starting value for the option.

In Figure SC 8-6, the binary forks in the tree-diagram determine the assumed annual prices to which

the stock can move. Had the tree-diagram been drawn with more nodes (e.g., monthly or daily prices),

these finite price points would resemble a smooth probability distribution. For basic tree-diagrams

such as those presented in Figure SC 8-6, Figure SC 8-7, Figure SC 8-8, Figure SC 8-9, and Figure SC

8-10, the model simplifies reality by assuming the stock price must fall within a given range. This


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range widens over time. The size of the range is driven primarily by the volatility assumption, although

risk-free interest rates may also influence these values in some versions of the lattice model. For

example, at time t3 (the vesting date) the stock prices are assumed to be within a range from $269 to

$44 based largely on the 30% volatility assumption. If the volatility was assumed to be 50%, the range

of possible stock prices at t3 would be from $490 to $24. This wider range would result in a higher fair

value for the option, because option value is derived only from the upside potential for stock price

appreciation.

Figure SC 8-6 Simplified binomial model of potential stock prices

In Figure SC 8-7, option values are calculated “backwards” in time from time t6 to time t0. For

simplicity, this figure demonstrates a simple valuation over the option’s expected term of six years.

Normally, a lattice model would simulate the entire contractual term (as illustrated in Figure SC 8-8,

Figure SC 8-9 and Figure SC 8-10). However, Figure SC 8-7 is presented only over the expected term

in order to provide a comparison to the fair value determined using the Black-Scholes model.


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Figure SC 8-7 Binomial model of option prices with a six-year expected term

Figure SC 8-7 provides possible option values (rounded to the nearest dollar) at the end of each year of

the option’s life up to the expected term of the option. The possible values are based on the possible

stock prices at time t6 (the expected term) illustrated in Figure SC 8-6. The option value at time t6 in

Figure SC 8-7 is equal to the greater of (a) the stock price at the corresponding point in Figure SC 8-6

minus $100 (the exercise price of the option) or (b) zero—i.e., the intrinsic value of the option in each

stock price scenario at the expected point of exercise.

The option values for points in time (tn) prior to time t6 are calculated by working backwards through

the tree using established formulas. These formulas involve weighting the two possible values from the

two possible nodes following any given node in the tree and discounting to reflect the time value of

money. The weightings applied to each possible upward or downward move in the tree are calculated

from the volatility and risk-free interest rate assumptions and resemble probabilities. In financial

theory, these weightings are called risk-neutral probabilities (which differ from actual probabilities).

Using the weightings to work backwards from the terminal (intrinsic) values at t6, the option’s grant

date fair value at t0 is derived from the various potential option values between t6 and t0.

In this example, the grant date fair value of the option obtained from this simple six step lattice model

with an expected term of six years is $35.88 (rounded to $36), which is close to the $35.29 value

calculated using the Black-Scholes model. Given identical assumptions, the results from a binomial

model should draw even closer to the Black-Scholes result as the number of time-points or nodes

shown in the binomial tree increases, because a large binomial tree approximates the type of

continuous distribution assumed by the Black-Scholes model. However, because of the additional


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flexibility to incorporate more varied assumptions with lattice models, it is likely that the fair value

estimates would not be as close in practice as in this example if varying assumptions about employee

exercise behavior depending on stock price over the full contractual life of the option were used in the

lattice model.

In practice, a binomial model would typically incorporate a large number of shorter time periods

(often daily) to reflect a realistic range of possible prices that a share could achieve over the option’s

contractual term, which could result in several thousand total nodes. In addition, various probabilities

could be assigned to each node to reflect the impact that a particular stock price scenario (node) is

expected to have in conjunction with exercise and post-vesting termination assumptions.

A more robust result can be achieved by using an iterative technique called a Monte Carlo simulation

(see SC 8.6), rather than developing a complex, full lattice model. This involves the use of a large

sample (e.g., 1,000,000 or more) of possible outcomes through a randomly generated process that

reflects the proportional distribution of each outcome’s probability and formula-based rules regarding

expected exercise patterns. When using one of these models, the fair value of the award is estimated by

averaging the results of the sample outcomes to minimize sampling error. Accordingly, it is important

that the number of outcomes used is sufficiently large.

8.5.2 Varying exercise patterns in option-pricing models

The example in Figure SC 8-7 still assumes a single value for the expected term of the option rather

than the more varied employee exercise behavior that would occur in reality, which may include the

correlation between possible stock price appreciation and the expected time of exercise. However, the

main reason to build a binomial model is to incorporate such assumptions over the option’s

contractual term. Because complex exercise pattern assumptions are not reflected in Figure SC 8-7,

the estimates of fair value produced by the Black-Scholes model and the simplified binomial model

will converge given a sufficient number of nodes.

One method to incorporate early-exercise behavior assumes exercises based on stock price

appreciation. As mentioned previously, a lattice model would simulate exercise behavior over the

entire contractual term, rather than simply using the single average expected term as illustrated in

Figure SC 8-7. Figure SC 8-8 shows another option valuation binomial tree-diagram, in which exercise

is assumed to occur whenever the stock price reaches $200 (i.e., the stock to exercise price multiple of

2.0 is a “threshold” at which exercise is assumed to occur at a date prior to the end of the contractual

term). The option value tree-diagram now covers the entire 10-year contractual life of the option

instead of the six-year expected term as in Figure SC 8-7, since the option values must be simulated

over the contractual life of the option in case the assumed exercise multiple is not reached. At time t10

(the end of the option’s contractual life), the option is assumed to be exercised immediately if it has

any intrinsic value at that point. If the stock price is less than the exercise price at time t10, the option

expires worthless (i.e., the value is zero).


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Figure SC 8-8 Option tree—ten-year contractual term with a 2.0 assumed exercise multiple

The values along the top boundary in Figure SC 8-8 will equal the option’s intrinsic value (the greater

of the stock price minus $100, or zero), similar to the values at time t6 in Figure SC 8-7. This boundary

may be thought of as the “exercise frontier” (i.e., the points along the price-time continuum at which

exercise is assumed to occur). As exercise is assumed to occur at these boundary points, no nodes

above that line are necessary. The calculation proceeds “backwards” from the terminal values using

risk-neutral probabilities and discounting for the time value of money. While the time-horizon

imposed by the option’s 10-year contractual life is reflected in this example, the constraint imposed by

the three-year cliff vesting assumption has no effect because the highest potential stock-price at time t2

(the last node before vesting in our simple one step per year example) is $193, which is less than the

assumed exercise threshold of $200. Refer to the corresponding node in Figure SC 8-6, which

illustrates the potential stock prices; the values in Figure SC 8-8 above represent potential option-

values.

The calculation shown in Figure SC 8-8 results in a fair value of approximately $42 or 17% higher than

the approximately $36 fair-value (based on the static six-year expected term) from Figure SC 8-7. The

use of an early-exercise assumption (i.e., the single average six-year expected term) will generally

reduce the estimated fair value of an option as compared to a model that considers the full contractual

life of ten years (on other than a dividend-paying stock, which can make it advantageous to exercise

early in some circumstances). However, depending on where the assumed exercise multiple is set

when exercise behavior is modeled based on stock-price appreciation, an option’s fair value could be

higher or lower than that of an otherwise similar option with an assumed static expected term.


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To explore the relationship between this type of early-exercise assumption and an option’s fair value,

Figure SC 8-9 presents another example, identical to the scenario presented in Figure SC 8-8, except

that exercise is assumed to occur whenever the price of the underlying stock reaches $130 (i.e., when

the assumed exercise multiple reaches 1.3).

Figure SC 8-9 Option tree—ten-year contractual term with a 1.3 assumed exercise multiple

The calculations in Figure SC 8-9 result in a fair value of approximately $27, 36% lower than the fair

value of approximately $42, calculated in Figure SC 8-8 (using an assumed exercise multiple of 2.0).

This dramatic decrease shows the sensitivity of fair value to the assumed exercise multiple—by

essentially truncating the model for significantly more valuable payouts by using a lower exercise

multiple, the fair value of the award is much lower. However, the calculation in Figure SC 8-9 may

require further adjustment to reflect the terms and conditions of the award. Specifically, the exercise

frontier shown in Figure SC 8-9 includes potential exercise scenarios as early as one year after grant

(i.e., at a price of $139 at t1, as shown in Figure SC 8-6), which precedes the three-year cliff vesting

date. Therefore, the unadjusted fair value calculation is based on assumptions that are inconsistent

with the terms and conditions of the award and must be adjusted.

Figure SC 8-10 illustrates the adjusted calculation for the exercise multiple of 1.3 limited by the

option’s three-year vesting condition. This results in an exercise frontier with three segments—a

vertical barrier at time t3, to reflect the vesting condition, a horizontal barrier from t3 to t10, to reflect

the exercise multiple of 1.3, and another vertical barrier at t10, to reflect the contractual term of 10

years. If the stock price were to go to its highest possible node at the end of the second year (time t2),

the option would be exercised at the end of the next year, because the stock price will be above $130,

with intrinsic value greater than $30 ($130 stock price minus $100 strike price) regardless of whether

the stock prices moves up or down from time t2 to time t3. The resulting calculation moves the


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estimated fair value to $34.56 (rounded to $35), very near to its estimated fair value in the original

binomial lattice using a six-year static expected term (approximately $35.88, rounded to $36 in Figure

SC 8-7).

Figure SC 8-10 Option tree—ten-year contractual term with a 1.3 assumed exercise multiple limited by the three-year

cliff-vesting condition

The results of the calculations in Figure SC 8-8, Figure SC 8-9 and Figure SC 8-10 are affected by the

use of one-year time-steps in the lattice model. These time-steps are intended to illustrate the

workings of the model. As noted earlier, a more realistic model would use shorter time intervals (e.g.,

daily) resulting in significantly more nodes. The model in Figure SC 8-7 with one-year time steps

resulted in a valuation fairly close to the Black-Scholes value using a simple six-year expected term. In

contrast, for the exercise assumptions in Figure SC 8-8, Figure SC 8-9 and Figure SC 8-10, a lattice

model with smaller time intervals could produce values that differ by as much as 20% from those

shown above. This is because the lattice values with the longer intervals may yield a stock price that

well-exceeds an assumed exercise threshold in a single step when the option would theoretically be

exercised at a lower price when shorter intervals are used. The values shown in the figures above are

rough approximations illustrating the general relationship between results and model inputs with

three-year cliff vesting and stock price volatility of 30%, as well as the exact calculations on a

simplified basis (note the relationships will vary with different vesting schedules and volatility

assumptions).

The examples shown above depict a constant exercise-frontier (except as affected by vesting or

expiration of an option). In a more elaborate binomial model, the assumed early-exercise frontier may


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have a different slope or may be a probability distribution curve, rather than a straight line, that varies

with both the price of the underlying stock and time. The binomial model can also incorporate

additional assumptions regarding post-vesting cancellations, as discussed in SC 9.3.3.

For complex binomial models that reflect the correlation of stock price and early exercise, software

applications may be employed to perform such modeling. As discussed further in SC 9.1, developing

these models and the underlying assumptions manually will require considerable time and effort.

The lattice model also may be used to develop an implied expected term assumption, which is a

required disclosure under ASC 718. The analysis of exercise patterns in a lattice model may yield an

expected term that is shorter (or longer) than the expected term used in an otherwise similar Black-

Scholes model. There are several methods to infer a single expected term from a lattice model, such as

the method included in ASC 718-10-55-30, which solves for an implied expected term in the Black-

Scholes model such that the Black-Scholes model’s fair value equals the lattice model’s fair value.

Using this method, with an assumed exercise multiple of 2.0, the expected term assumption inferred

in Figure SC 8-8 is approximately 8.2 years. Using the risk-neutral expected life method, the inferred

expected term assumption is approximately 8.3 years. For typical options, the theoretical, inferred,

risk-neutral expected term is much longer than the more realistic, and easily interpreted, implied

Black-Scholes expected term.

There is a third method that would involve using a risk-adjusted expected rate of return in conjunction

with early exercise assumptions built into the lattice model. The expected term assumption disclosed

for companies using lattice models will therefore vary based upon the method used to infer it. The

method used to infer the expected term should be applied consistently.

8.5.3 Using lattice models

Because lattice models are flexible, they can accommodate a variety of situations and assumptions.

Four specific adaptations of lattice models are:

□ Dynamic assumptions: Assumptions about volatility, the risk-free interest rate, and the

dividend yield, which can vary over the award’s contractual term.

□ Awards with market conditions: Specific nodes of the lattice can be “turned off” to exercises

to model an assumption that the option vests only if the underlying stock (or total shareholder

return) reaches a pre-set level by a pre-set time (often called path-dependent models).

□ Awards with caps: Maximum value awards impose a contractual cap on the gain that employees

may realize (e.g., the gain is capped at twice the grant date stock price). Lattice models are

required to value such awards (or alternatively a Monte Carlo simulation model could be used).

For an option, this is because the timing of early exercise for options with caps is generally more

correlated with stock price appreciation as compared to ordinary options. As a result of this

correlation and the limit on the gain that an employee may realize (for either an option or other

award), the fair value of a maximum value option may be significantly lower than an ordinary

option or uncapped award.

□ Incorporated patterns of early exercise: Assumptions that may include the correlation

between the stock price and the time of exercise, forced early exercise due to post-vesting

termination, and the probability of exercise over the full period from the vesting date to the

option’s contractual expiration date (see SC 8.5.4 for an illustrative example).


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When valuing options with service conditions only, the primary reason to use lattice models instead of

the Black-Scholes model is to incorporate more detailed assumptions about employee exercise

behavior. Companies considering whether to use a lattice model or the Black-Scholes model should

consider their specific circumstances. For options on shares of a company with a relatively low stock

price volatility and a longer vesting schedule, a simple lattice model may not yield a significantly more

refined estimate of fair value than a Black-Scholes model using an appropriately developed weighted-

average expected term assumption. Further, not all companies will have the necessary historical data

required to support a more complex lattice model. These factors, taken together with the option to use

a simplified method to calculate the expected term for “plain vanilla” options (as described in SC

8.4.1), may make the Black-Scholes model the more practical approach for valuing many “plain

vanilla” options.

In general, the development of appropriate assumptions—inputs to the valuation model—is more

critical than the model—Black-Scholes or lattice—for many typical option grants. SC 9 discusses the

factors to be considered in the development of assumptions.

8.5.4 Incorporating exercise patterns into a lattice model

To understand various techniques for incorporating early exercise patterns into a lattice model,

consider a simplification that is used in many of the illustrations that appear in ASC 718. The exercise

of 100% of the options is assumed to occur when the underlying stock reaches a certain price. Using

this assumption is similar to using a single value for the expected term, except that it assumes options

are exercised when a specific stock price is reached, instead of after a specific time period. An

appropriate lattice model, at a minimum, should capture early exercise patterns as a function of at

least four factors: (1) the assumed exercise multiple(s), (2) the vesting period, (3) the contractual term,

and (4) the assumed post-vesting termination rate(s). These factors replace the single expected term

assumption that is used in the Black-Scholes model.

Companies that intend to utilize lattice models should consider how much complexity to incorporate

into the models and the effort necessary to gather the additional information needed to support the

more sophisticated assumptions. In practice, simpler lattice models do not always produce results that

are more refined or even as reliable as a Black-Scholes model with simple but well-supported

assumptions.

As described earlier, the exercise-multiple (or suboptimal exercise factor) is an assumption about early

exercise behavior based on stock price appreciation rather than the time that has elapsed since the

grant date. This factor is called suboptimal because traditional financial theory suggests that the

optimum behavior is to hold an option until its contractual expiration date. Although suboptimal from

a financial theory perspective, it may nevertheless be reasonable for an employee to exercise stock

options early, given the fact that typical employee options cannot be sold or hedged and considering

individual employee’s risk tolerance or liquidity needs. For example, a suboptimal exercise factor of 1.5

assumes that employees will voluntarily exercise options granted at-the-money when the price of the

underlying stock price rises 50% above its price on the grant date. Typically, larger suboptimal

exercise factors are associated with higher volatility stocks. Because of the sensitivity of an option’s fair

value to the early exercise assumption, it is particularly important that any suboptimal exercise factor

in a lattice model be reasonable in the context of the specific company circumstances, the nature of the

award, and the relevant employee demographics.

In addition to the other assumptions, lattice models should include an assumed post-vesting

termination rate. Under most option plans, employees who terminate their employment have a short


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period (e.g., 90 days) to exercise their vested options. Lattice models typically assume that employees

subject to truncation of the option’s contractual term will exercise their options immediately upon

termination if the options are in the money, and that out-of-the money options will always be

cancelled upon termination.

In order to maximize the precision provided by a lattice model, more complex assumptions may need

to be developed to reflect suboptimal exercise factors that change during the option’s contractual term.

For example, for an option with a three-year vesting provision and a ten-year contractual term, the

assumed suboptimal exercise factor might be 1.8 in years 4-5, 1.5 in years 6-7, 1.4 in years 8-9, and 1.2

in year 10. Such an assumption reflects the notion that employees may demand larger payoffs to

exercise options in the early years after grant but settle for less gain as the contractual term nears its

end. Extending this concept even further, probability of early exercise can be added to the model to

create a distribution of early exercise factors. For instance, in the above example for years 4-5, instead

of assuming all employees will exercise when the stock price reaches 1.8 times the grant price, it could

be assumed that, on average, one-third of the options will be exercised at a suboptimal exercise factor

of 1.3, one-third at 1.6 and one-third at 1.9.

The following sections illustrate the use of suboptimal exercise factor(s) and the assumed post-vesting

termination rate in a lattice model.

8.5.5 Dynamic suboptimal exercise factors in a lattice model

Figure SC 8-11 expands the binomial approach to reflect suboptimal exercise factors that change

during the option’s contractual term. This version of the lattice model uses a probability distribution of

early exercises as it considers a scenario where employees would voluntarily exercise their options

early (suboptimally) at stock price appreciation levels that vary by post-vesting sub-period. This

distribution of early exercise patterns might be refined over time with the company’s new grants to

reflect the observed variance around the expected level of stock price appreciation that results in early

exercise. Figure SC 8-11 illustrates an equally-weighted probability distribution using three different

suboptimal exercise factors for each of four post-vesting sub-periods.

This example assumes that employees will, on average, exercise one-third of the outstanding vested

options on each trading day when the stock price is at least equal to the lowest suboptimal exercise

factor, an additional one-third of the outstanding vested options will be exercised when the stock price

is at least equal to the midpoint suboptimal exercise factor, and the remaining one-third will be

exercised when the stock price is at least equal to the highest suboptimal exercise factor. This

probability calculation occurs at each node of the lattice to simulate trading days. In other words, the

assumption is that there is a 33% probability of early exercise of the outstanding vested options on the

trading days when the stock price is between the lowest and middle suboptimal exercise-factors, a 67%

probability of exercise when the stock price is between the middle and highest suboptimal exercise

factors and a 100% probability if the highest stock price level has been reached. In addition, a small

number of employees will be assumed to terminate employment after vesting, meaning their options

will be exercised immediately (if in-the-money) or cancelled (if out-of-the money).

This example uses a much more detailed binomial lattice than was used in the previous examples

(Figure SC 8-6, Figure SC 8-7, Figure SC 8-8, Figure SC 8-9 and Figure SC 8-10). In order to

incorporate an early exercise assumption, the binomial model used with the assumptions shown below

has 252 nodes per year (to reflect the number of market trading days in a year) over a full ten-year

period, so there are approximately three million possible nodes, as opposed to the 28 nodes in Figure

SC 8-7.


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Figure SC 8-11 illustrates a binomial model with probability-based exercise distributions of suboptimal exercise factors.

Figure SC 8-11 Binomial model with probability-based exercise distributions of suboptimal exercise factors


Exercise price $100

Vesting period (cliff vesting) 3 years





Years after grant date Suboptimal exercise

factors Annual post-vesting

termination rate

At least 3 but less than 5 1.3, 1.6, 1.9 3%




Monte Carlo techniques were used to simulate probability-based early exercise in Figure SC 8-11. The

assumed suboptimal exercise factors decline over the option’s contractual term. This assumption is

designed to replicate an effect observed by economists; namely, that employees may demand larger

payoffs before voluntarily exercising their options when there is a longer time remaining in the

contractual term for them to exercise. It is assumed that employees will exercise all in-the-money

options by the expiration date. Figure SC 8-11 also assumes a constant post-vesting termination rate

for simplicity.

Based on the assumptions in Figure SC 8-11, the binomial lattice model produces a fair value per

option of $36.21. The increase over the fair value of $34.56 derived in Figure SC 8-10 based on a single

suboptimal exercise factor of 1.3 reflects the higher suboptimal exercise factors in the earlier years

from grant date (lower probability of early exercise). These fair values are both relatively close to the

Black-Scholes model fair value for these options (as determined in Figure SC 8-5 using a 6 year

expected term) of $35.29. For purposes of comparison, the implied expected term corresponding to

this example equals 6.3 years. This implied expected term was calculated using the method described

in ASC 718-10-55-30 (the expected term necessary for the Black-Scholes value to equal the lattice

model value).

Companies should be cautious about using a single suboptimal exercise factor in their models, as they

may underestimate fair value unless there is sufficient support for the assumption that there is a single

level of price appreciation (measured as a proportion of exercise price) at which early exercise by

employees actually tends to occur. However, a company will have difficulty either assessing

reasonableness or estimating the effects of using various types of lattice models without actually

building such models—like the example in Figure SC 8-11—and doing the work necessary to develop


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and support appropriate assumptions. In the absence of a lattice model that incorporates complexities,

such as probabilistic exercise, companies may be better served by using the Black-Scholes model with

well-supported assumptions rather than attempting to implement a simplistic lattice model, especially

for “plain vanilla” awards with longer vesting schedules.

8.5.6 Option-pricing models for awards with market conditions

The terms of some awards require that vesting or exercisability depend on achieving a market

condition. For example, an option with a market condition may provide that the option cannot be

exercised unless the stock price rises by 50% from the grant date price. Performance shares (generally,

a promise to issue shares, or entitle employees to vest in share awards, if certain performance targets

are met) may also contain market conditions. Awards with market conditions require the use of a

lattice model or a Monte Carlo simulation to estimate fair value. For example, a restricted stock unit

may contain a provision that vesting is contingent on the company’s total shareholder return

exceeding the total shareholder return of a specified peer group over a stated number of years.

Figure SC 8-12 illustrates an option that will vest only after the stock has traded at $150 or more for

twenty consecutive trading days and the employee completes three years of service. The option will

lapse if the stock does not reach its targeted price within three years of the grant date. The award

includes a service condition and a market condition.

Figure SC 8-12 Option that vest after three years of service if a targeted stock price is achieved within three years

Stock price at grant $100

Exercise price $100

Targeted (threshold) stock price $150 (for 20 consecutive trading days)

Vesting period (cliff-vesting) After 3 years of service if achievement of targeted stock price within 3 years of grant date

Expected term Date of achievement of targeted stock price plus 3.5 years, which may vary from about 3.6 to 6.5 years depending when target price is reached (assumption not relevant if target price not reached because option will not vest)

Full contractual term 10 years

Expected annual volatility of the underlying stock

30%

Expected annual dividend yield on stock 0%

Risk-free interest rate (continuously compounded)

3%


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A Monte Carlo simulation or lattice model should be used to estimate the fair value of an option with

this type of market condition because it is the only way to simulate the many possible ways stock

prices can move to meet the targeted stock price.

Using a Monte Carlo technique with daily stock price intervals to simulate an appropriately large

binomial model yields a fair value estimate of $24.26. This fair value estimate is considerably less than

the valuations of similar options without a market condition (see Figure SC 8-6, Figure SC 8-7, Figure

SC 8-8, Figure SC 8-9 and Figure SC 8-10).

On the other hand, the estimate of $24.26 is greater than the valuation that would result if the actual

stock price had to be at or above the targeted stock price on a specific vesting date, for example, three

years after grant (with otherwise similar assumptions as in Figure SC 8-12). These differences should

be intuitive in that an option with a market condition is clearly worth less than an option that vests

over the same time regardless of stock-price appreciation. Further, an option that can achieve the

target stock price anytime during a three-year period offers the holder greater flexibility (possible early

vesting, with potential gains in the case of early steep stock-price appreciation) and thus should be

worth more than an option that vests only if the stock price is at or above its target price upon

completion of three years of service.

Other assumptions in the valuation model for awards with market conditions should be tailored to

reflect the award’s terms. For example, in Figure SC 8-12, because the options vest based on stock

price movements, using a single expected term assumption would not be reasonable. Rather, a lattice

model or Monte Carlo simulation is needed to reflect the fact that exercise could occur early if the

stock price reaches $150 relatively early in the required three-year service period. The model uses a

simplified exercise assumption of three and one-half years after achieving the target stock price to

reflect the contingent nature of the vesting date and a typical holding period after vesting. More

refined early exercise assumptions could also be appropriate.

A lattice model or Monte Carlo simulation should also be used to value an award that involves the

achievement of multiple possible market conditions. For example, an option that will vest if the share

price doubles within the next two years or if it triples within the next five years and the employee stays

with the company until either condition is met should be viewed as one award, with a fair value

determined by a lattice model or Monte Carlo simulation.

Market conditions are typically modeled using an approach that incorporates a Monte Carlo

simulation (involving a series of random trials that may take different future price paths over the

award’s contractual life based on appropriate probability distributions). Conditions are imposed on

each Monte Carlo simulation to determine if the market condition would have been met for the

particular stock price path. For example, in modeling the market condition in Figure SC 8-12, each

simulated stock price path was checked to determine whether the stock reached the $150 threshold

during the vesting period.

The point at which the stock price achieves the threshold in each scenario in the simulation is also

important in determining fair value. This technique for modeling awards with market conditions is

called path-dependent modeling because it simulates many possible stock price paths through the

lattice (or simulation) to arrive at the outcome. The award’s grant date fair value is determined by

taking the average of the grant date fair values under each of the scenarios in the Monte Carlo

simulation.


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In addition, the median path of successful trials for the market condition is used to develop the derived

service period (as described in SC 2). The pattern of expense recognition will depend on this value in

many cases (see SC 2.6.2 for more details).

8.6 Monte Carlo models

A Monte Carlo simulation model assumes that the underlying entity’s stock price follows a Geometric

Brownian Motion stochastic process. Geometric Brownian Motion is an accepted methodology for

simulating the expected future path of stock prices. Stock prices are simulated at regular intervals

(daily, monthly, annually) depending on award conditions and precision of estimate desired.

A large number of sample paths are simulated and a fair value of the award is determined for each

sample path outcome based on the payout value of the award discounted to the grant date. The fair

value of the award is estimated as the average value of the fair values calculated for each sample path.

Like a lattice or Black-Scholes model, it is first necessary to develop assumptions for the initial stock

price, volatility, dividend yield, and any other pertinent factors given the awards’ terms.

A discussion of the theoretical underpinnings of the Monte Carlo simulation is outside the scope of

this guide. However, we note that best practices have developed for the use of Monte Carlo simulation

and the use of such models (with the assistance of an outside valuation specialist) is now

commonplace.

A fairly large number of companies issue awards that contain (sometimes complex) market conditions.

Valuation of these award types generally requires the use of a Monte Carlo simulation.

Chapter 9: Developing assumptions for option-pricing models

Developing assumptions for option-pricing models

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9.1 Developing assumptions for option-pricing models overview

The assumptions a company develops when measuring the fair value of employee stock options or

other equity instruments generally will have more impact on fair value than the option-pricing model

it uses. This chapter discusses the key assumptions that drive fair value, certain simplifying

alternatives available in limited circumstances, and techniques for analyzing historical and current

data used to develop and support the following assumptions:

□ Expected term

□ Expected volatility

□ Risk-free interest rate

□ Expected dividend yield

9.2 Background of assumptions for option-pricing models

As discussed in SC 8, option-pricing models require six inputs, four of which are assumptions that

require significant management judgment:

□ Expected term, which can be affected by early exercise and post-vesting termination behavior

□ Expected volatility of the underlying stock price

□ Risk-free interest rate

□ Expected dividend yield on the underlying stock

The two remaining inputs—exercise price (applicable only for options and defined by the terms of the

award) and the fair value of the underlying stock on the measurement date (based on observable

market prices in the case of publicly-traded securities), are not discussed in this chapter. For

nonpublic entities, an enterprise valuation may be necessary to determine the fair value of the stock;

refer to FV 7.3.2, Business enterprise valuation.

ASC 718, Compensation—Stock Compensation, explicitly requires that the assumptions used in an

option-pricing or equity valuation model be reasonable and supportable. The assumptions should also

reflect the substantive characteristics of the award and all other relevant facts and circumstances.

SAB Topic 14 provides helpful interpretive guidance for SEC registrants related to the application of

ASC 718, acknowledging that there may be a range of reasonable judgments in developing

assumptions for option-pricing models. SAB Topic 14 also provides registrants with certain simplified

alternatives for developing the expected term and expected volatility assumptions, subject to certain

conditions. These alternatives are discussed in SC 9.3.1 and SC 9.4. ASC 718-10-30-20A through ASC

718-10-30-20B provides a similar, but slightly broader, practical expedient for determining the

expected term for nonpublic companies. If a company cannot or chooses not to use the simplified

alternatives, then it should develop its assumptions starting with consideration of its own relevant

historical data and adjusting that data, if necessary, for its future expectations.


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An option’s expected term and the expected volatility of the underlying stock are usually the most

difficult assumptions for a company to develop because the same underlying data often could support

a range of possible estimates and be segregated and analyzed in a variety of ways. Even the more

straightforward assumptions with typically narrower ranges (i.e., risk-free interest rate and the

expected dividend yield) can involve choices and approximations, and therefore judgment.

Management should consider all relevant factors when developing its assumptions. Lattice or Monte

Carlo models generally require additional and more detailed assumptions than the Black-Scholes

model because the Black-Scholes model reduces several separate assumptions to a single value.

However, the key concepts and data used to support these assumptions are the same for both types of

models.

ASC 718-10-55-23 and SAB Topic 14 acknowledge that there is likely to be a range of reasonable

estimates for expected term, volatility, dividend yield, and the resulting fair value. ASC 718 requires

that if a best estimate cannot be made, management should use the mid-point in the range of equally

likely reasonable estimates.

Note about ongoing standard setting

In August 2020, FASB issued an exposure draft that proposes a practical expedient for the

determination of the current price of an underlying share for equity-classified stock option awards

issued by nonpublic companies. As of the cut-off date of this guide, the proposed amendments have

not yet been issued. Reporting entities should continue to monitor the status of these proposed

amendments.

9.3 Developing the expected term assumption

When valuing an employee option under the Black-Scholes model, companies should use the option’s

expected term rather than the contractual term. SAB Topic 14 reinforces the guidance in ASC 718 that

the nonhedgeability and nontransferability of most employee stock options is not considered in fair

value, except as it affects the expected term assumption. Additionally, pre-vesting forfeitures should

not be factored into the determination of expected term because they are taken into account by the

company recognizing compensation cost only for those awards for which employees render the

requisite service. As described in SC 9.3.10, certain other factors may be considered when a company

develops its expected term assumption.

Companies should consider the following factors in developing an expected term assumption for use in

the Black-Scholes model or in developing the group of assumptions related to the expected exercise

patterns in a lattice or Monte Carlo model:

□ Vesting period of an award

□ Contractual term of an award

□ Historical exercise and post-vesting cancellation experience with similar company-specific grants

(i.e., historical average holding periods)

□ Stock price history

□ Expected volatility (which may be inversely correlated with the expected term)


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□ Blackout periods that may trigger automatic early exercise or delay exercise

□ Plan provisions that require exercise or cancellation of options shortly after employees terminate

□ The extent to which currently available information indicates that the future is reasonably

expected to be similar or different from the past

Because employees typically cannot exercise an option until it vests, the vesting date represents the

earliest end of the range of possible exercise dates, whereas the contractual term represents the latest

end of the possible range. An analysis of historical exercise and post-vesting cancellation behavior is

generally used to estimate where within this range the exercise or post-vesting cancellation may occur.

If the award has an acceleration feature (e.g., immediate vesting upon a change in control of an IPO of

a certain size), the vesting date used to determine the expected term should incorporate the probability

that an award’s vesting will be accelerated. A company should use its relevant historical experience for

similar options and employee groups. If a company’s specific historical data is insufficient, ASC 718-

10-55-32 and SAB Topic 14 allow the company to use other publicly available data, such as financial

statements of similar companies or published academic research. For example, if a company has a

history of option grants and exercises only during periods in which the company’s stock price was

rising sharply, the exercise behavior related to those options likely would not be a sufficient basis to

develop the expected term assumption because it would be unreasonable to assume that the stock

price will continue to rise in a similar manner. In a case like this, the company might instead rely on

academic studies, disclosures from similar companies with similar grants to similar employee groups,

or might elect to use the simplified method (as discussed in SC 9.3.1).

When a company uses published academic research or industry data to estimate employees’ exercise

behavior, it should consider how the awards and companies that sourced the data compare to its own

awards, including the following attributes:

□ Vesting periods

□ Contractual terms

□ Blackout periods

□ Stock-price volatility

□ Demographics of employee populations (which may affect employees’ attitudes toward risk and

patterns of exercise)

□ Any other company-specific attributes that can affect employee exercise behavior

It may be difficult in some cases to identify similar companies that grant similar types of awards to

similar populations of employees, but the objective is to ensure that the most relevant data available is

used to inform management’s judgments.

9.3.1 Simplified method for estimating expected term

SAB Topic 14 provides a simplified method for estimating the expected term for “plain vanilla” options

that significantly reduces the analysis required to estimate expected term. This simplified method is

only acceptable if (1) a company does not have sufficient appropriate exercise data on which to base its


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own estimate or (2) exercise data relating to employees of comparable companies is not easily

obtainable. SAB Topic 14 also stipulates that the simplified method should no longer be used once a

company has sufficient exercise data in which to base its own estimate or more relevant general

information (e.g., published academic or industry-sponsored research) becomes available on employee

exercise patterns.

Question 6 in SAB Topic 14-D.2 provides the criteria necessary for application of the simplified

method, as follows:

□ Stock options are granted “at the money”

□ Exercisability depends only on completing a service condition (i.e., continuing to work through the

vesting date)

□ Employees who terminate their service prior to vesting forfeit their options

□ Employees who terminate their service after vesting have only a limited time (typically 30-90

days) to exercise their stock options

□ Stock options are nontransferable and nonhedgeable

If a company grants awards that do not meet the SAB Topic 14 criteria, the simplified method cannot

be used and historical exercise data is required to be the starting point to develop the expected term

assumption. See SC 6.2.3 for guidance regarding the use of the simplified method by nonpublic

companies in ASC 718-10-30-20A through ASC 718-10-30-20B. Scenarios where use of the simplified

method under SAB Topic 14 may be appropriate include:

□ Insufficient historical experience for option grants overall

□ Substantial changes in the contractual terms or vesting periods of options granted

□ Changes in a company’s business or employee population, rendering historical experience

irrelevant to expectations for current grants

In addition, SAB Topic 14 specifically states that the simplified method is not intended to be applied as

a benchmark in evaluating the reasonableness of more refined estimates of expected term.

The simplified method uses the mid-point between the vesting period and the contractual term for

each grant (or for each vesting-tranche for awards with graded vesting) as the expected term. For

awards with graded vesting, the time from grant until the mid-points for each of the vesting tranches

may be averaged to provide an overall expected term.

See Figure SC 9-1 for an illustration of how a company would apply the simplified method of

estimating the expected term of an award with a four-year, graded vesting schedule (see additional

illustration in footnote 77 of SAB Topic 14). If the SAB Topic 14 criteria are met, this method can be

used regardless of the attribution method used to recognize compensation cost (see SC 2.8 for

information on attribution methods).


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Figure SC 9-1 Application of the simplified method of estimating expected term

The following is the calculation of the expected term by vesting tranche:

Expected term = Vesting period + [(Contractual term - Vesting period) ÷ 2]

Tranche1 = 1 + [(10 - 1) ÷ 2] = 5.5

Tranche2 = 2 + [(10 - 2) ÷ 2] = 6.0

Tranche3 = 3 + [(10 - 3) ÷ 2] = 6.5

Tranche4 = 4 + [(10 - 4) ÷ 2] = 7.0

∑Tranche1-4 = 25.0

The following is the calculation of the expected term for all vesting tranches:

Simplified expected term = Total of expect terms for each tranche Total number of tranches

Simplified expected term = 25.0 years ÷ 4 tranches

= 6.25 years

9.3.2 Evaluating historical exercise data for expected term

Because most public companies have historical data on their employees’ exercises of stock options,

that should be the starting point for developing the expected term assumption. When completing the

analysis, a company should (1) track behavior on an employee-by-employee basis from the grant date

through the settlement date (e.g., exercise or post-vesting cancellation) and (2) make adjustments for

any changes in award terms during the historical period in relation to current awards (i.e., where the

history may not be indicative of the future). In order to appropriately develop the expected term

assumption for a new award, a company should analyze historical information on options:

□ whose recipients would be expected to exhibit similar exercise and post-vesting termination

behavior,

□ with a similar contractual term to expiration,


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□ with a similar vesting schedule, and

□ with other contractual provisions similar to the award being granted.

Additionally, a company should consider whether it has an anomalous stock price history that may

indicate that its historical exercise patterns may not be predictive of future exercise patterns (for

example, if options were under water during most of the available exercise period or there was a sharp

increase in the company’s stock price over a long period of time). Once this information is collected

and analyzed, a company can estimate a historical average holding period (period from grant to

exercise) for its employee options. See SC 9.3.5 and SC 9.3.6 for information about adjustments for

anomalous historical periods.

If the demographics of the groups of employees receiving options have changed over time, a company

may need to make adjustments to historical exercise data before arriving at an expected term

assumption for the latest grant. The company could still leverage its historical data, but should adjust

it to reflect the new demographics (for example, by using the historical data for only those employees

who exhibit similar characteristics to the current covered group, or by appropriately re-weighting the

various considerations underlying the expected term assumption). Similarly, if certain events or policy

shifts have affected exercise behavior in the past, a company may have to isolate and remove portions

of its historical data in favor of recent or more relevant information. In addition, the behavior of

employees affected by a prior merger or spin-off may be different from what the company can expect

from its current employees.

When analyzing historical exercise information, consideration should also be given to whether

exercises generally happen evenly throughout the year or if there are seasonal effects. If exercises

happen evenly throughout the year, this assumption can be used to simplify the historical calculation.

If exercises are not spread evenly, a more refined approach to calculating the term of each exercise

may be appropriate.

9.3.3 Pre-vesting forfeitures vs. post-vesting cancellations

The expected term assumption is intended to reflect the settlement of all vested options, including

voluntary exercise, forced exercise (i.e., upon employee termination), and expirations. The term “post-

vesting cancellations” refers to all events that may lead to a vested option not being exercised. These

events, which occur once employees vest, need to be considered when developing the expected term

assumption. In contrast, because previously recognized compensation cost is reversed for awards that

are forfeited prior to vesting, a company would not consider pre-vesting forfeitures in determining the

expected term assumption.

The expected term assumption should also reflect the possibility that some vested options may never

be exercised because they will expire under water while the holder is still an employee. In computing

historical average holding periods, a company should count those expired vested options as though

they were exercised at expiration, because it reflects the period the awards were held by the employee.

Companies should consider the distinction between pre-vesting forfeitures and post-vesting

cancellations when developing their expected term assumption. Some software packages used to

administer stock-based compensation plans do not correctly segregate pre- and post-vesting events,

which may inadvertently skew a company’s expected term analysis by either incorrectly increasing or

decreasing its expected term assumption. In addition, segregation of voluntary and forced early exercises


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(upon termination of employment) is generally necessary for development of the expected term

assumptions under a lattice model.

9.3.4 Adjustments for partial life-cycles

Companies should make adjustments for potential bias due to recently granted unexercised options to

account for what is called the partial life-cycle effect. For example, if a company typically issues

options with a contractual term of ten years, the only exercise data covering a full life-cycle is likely to

be for options issued ten or more years ago, as some options from more recent grants would, in all

likelihood, remain unexercised. If the company does not make some adjustment for these outstanding

options and instead calculates the average holding period based on partial exercise and post-vesting

cancellation data, the expected term assumption and resulting fair value will most likely be too low,

because it will not include the impact of outstanding options that will be exercised, expired or

cancelled (post-vesting) at a later date.

Additionally, companies should consider whether to only include option grants that are fully vested or

to also include partially vested awards. This decision will depend on whether or not emerging

experience is different from prior exercise experience as well as the amount of total data available.

Several methods of adjusting exercise data for the partial life-cycle effect exist, such as those listed

below:

□ Exercised at expiration. While some recordkeeping software assumes outstanding options will

be held until the end of their contractual term, this generally overstates the expected term

assumption because, as practice has proven, there is no reason to believe that all outstanding

employee options will be held until expiration. Accordingly, other approaches to adjust for the

partial life-cycle effects, such as those described below, are generally more appropriate.

□ Exercised uniformly over remaining term (between the later of vesting date and date

of the analysis, and the contractual expiration date of each option). This method is an

impartial approach for estimating expected term, but it may not be appropriate in all situations.

For example, if there is clear evidence that non-uniform exercise patterns occur in the later years

of options’ life-cycles, the uniform exercise approach method for dealing with outstanding options

should not be used.

□ Marginal exercise rates. This more sophisticated method involves estimating marginal

exercise rates to complete the life-cycle for each grant. Using this approach, a company determines

the weighted-average percentage of options for each grant year (e.g., 20X1) that were exercised in

a given period post-grant (e.g., in 20X4, 20X5) in relation to all options for that grant year eligible

to be exercised in each given period. These percentages can be averaged over the grant years and

then used to model a distribution of expected exercises that reflects all available data in an

unbiased manner. If a company has only partial data (e.g., it grants ten-year options but has only

five years of history), the marginal rates for the final years could also be estimated using published

data, if available. If no published data is available, it may be reasonable to combine estimated

marginal exercise rates for earlier life-cycle years with a uniform exercise assumption for later

years, spreading outstanding options evenly over life-cycle years after the last year for which

marginal rates could reasonably be estimated.


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9.3.5 Adjustments for insufficient historical data

The sample size of historical exercises should be large enough to generate a reliable expected term

assumption. The appropriate sample size of historical exercises depends on the inherent variability

within the data and the number of adjustments a company has to make to that data. An otherwise

large amount of data may not be sufficient if options were either significantly in-the-money or out-of-

the-money during much of the observation period, or a significant company-specific event (e.g.,

downsizing) occurred that significantly affected exercise patterns.

If management believes that the expected term assumption derived from historical company-specific

data is a poor indicator of future exercise patterns, it could use appropriate subsets of that data, or use

data from other sources to replace or supplement the company’s data. Some compensation consulting

firms compile databases of exercise information collected from a large sample of companies of various

sizes in different industries in order to (1) supplement the datasets from the limited number of

academic studies on this subject and (2) provide companies with a wider dataset from which to build

more refined expected term assumptions.

Companies that conclude they have inadequate exercise history and no access to alternative sources

may use the simplified method discussed in SAB Topic 14 (see SC 9.3.1) if certain criteria are met. For

example, if a company has a significant history of option grants, but nearly all of those grants have

been continuously or nearly continuously out-of-the-money, the available exercise windows may yield

only negligible exercise data. Another example is when a new company has made significant grants but

most are still unvested. Basing an expected term on the limited exercise data available may not yield a

reasonable assumption.

9.3.6 Adjustments for stock price movements

Companies should consider whether exercise patterns are affected by shifting risk-preferences among

employees or other external conditions. The most important external condition is stock price

movements; employees’ exercise decisions are frequently affected by stock price patterns.

Option pricing models implicitly consider several potential stock price paths. Accordingly, a company

should not base the expected term of new options on historical data that reflects a unidirectional stock

price trend – i.e., only rising (bull market) or falling (bear market) stock-price history. A

predominantly bull market sample would tend to result in estimates that understate the expected

term, while a bear market sample would tend to overstate it.

Lattice models, by design, as described in SC 9.3.11.1, directly address this over/understatement

problem. But when the Black-Scholes model is used, adjustments may be necessary to deal with a

largely unidirectional historical stock-price pattern. The following are three generally appropriate

ways to address this situation:

□ Use more historical information to dilute the effect of periods strongly influenced by unusual

market movements

□ Use data from academic or compensation consultants’ studies as a basis or to supplement the

historical data

□ Use an approach similar to the SAB Topic 14 simplified method (with appropriate adjustments to

reflect the facts and circumstances of the award or grantee population).


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In general, it would not be appropriate for companies to selectively use small portions of relatively

recent historical exercise data, while excluding other portions based on unusual stock price

movements. That approach would imply a forecast of future stock price movements, while financial

theory assumes that future price-changes are not foreseeable. Historical exercise data that is strongly

influenced by unusual stock-price movements should either be considered entirely irrelevant to future

expectations, or possibly used to support an estimate that might be blended with estimates based on

other sources, depending on how unusual the historical stock-price path is.

Companies should carefully observe the effect of stock price changes on exercise patterns, especially

for more recent data, as the effects of stock prices might interact with the partial life-cycle effect. For

example, if a company had a consistently rising stock price until five years ago, at which time the stock

price began to fall, its pattern of exercises will likely indicate that employees are tending to hold their

options longer for more recent grants. Due to the partial life-cycle effect, however, the average time

until exercise for grants made in the past five years may still be much shorter than for older grants. If

the outstanding options from these recent grants are extrapolated over their remaining lives, or

alternatively, if more sophisticated marginal exercise rate analyses are employed on the data, a pattern

of a lengthening holding period may become apparent. Observing this effect highlights the need to

combine appropriately adjusted data from recent grants into the overall estimate of future holding

periods.

Sometimes employees’ appetite for risk and their exercise patterns change despite consistent stock

performance. In such cases, a company should consider basing its estimates of future exercise

behavior on data that largely reflects recent exercise patterns.

9.3.7 Using historical exercise data to calculate expected term

Once a company analyzes and, if necessary, adjusts its historical exercise data, it can use this data to

calculate the expected term. This entails obtaining a weighted average of the holding periods for all

awards (i.e., the average interval between the grant and exercise or post-vesting cancellation dates)

adjusted as appropriate. While companies can sometimes group options by the month of their grant

and/or exercise date, using the exact number of days between the grant and the exercise dates yields a

more accurate expected term assumption.

9.3.8 Stratifying the employee population for expected term

This section has so far focused on developing a single expected term assumption for all grants made to

the entire employee population. However, different types of employees (e.g., management vs. non-

management) or employees of different ages or geographic location may have different appetites for

risk and thus different propensities to exercise early. Thus, using a different expected term assumption

for different groups of employees will likely yield a more refined estimate of exercise behavior.

Stratification may be by position, salary range, geography, age, or any other factor that could affect

exercise behavior.

Because fair values produced by the Black-Scholes model are not a linear function of the expected

term, stratification of the employee population by the expected term assumption generally has less

impact on the fair value of an option with a longer average expected term than one with a shorter

average expected term. Typically, the average fair value estimate derived using different expected

terms for different groups of employees is marginally lower than if a single expected term is used for

all employee groups. Even though the average per share fair value weighted for class size may only be

marginally different after stratification, the ultimate cumulative expense may be impacted to a greater


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degree if different groups of employees have significantly different rates of forfeiture. Therefore, if

there are sub-groups of employees with significantly different expected exercise behavior and

forfeiture experience, whose options represent a significant percentage of total company options

granted, development of a separate expected term assumption should be considered for each one,

provided there is relevant data upon which to develop these stratified assumptions.

9.3.9 Stratifying by vesting tranche for the expected term

ASC 718 allows valuation of options with graded vesting using a single expected term assumption for

the entire grant or separate expected term assumptions for each tranche of the award. The practice of

stratifying assumptions by vesting tranches will create an incremental (albeit small) reduction in

aggregate compensation cost because stratifying by vesting tranche can separate early-exercising

options (generally a lower fair value) from later-exercising options (generally a higher fair value).

When analyzing exercises by vesting tranche, one potential challenge is that the option exercises are

often not specifically tracked, or linked, to a specific tranche. For example, if an employee has vested

in awards from two separate tranches and then exercises a portion of those vested options, typically

there are no detailed records of which tranche of options were actually exercised. Although GAAP is

silent, we believe it would be appropriate in these circumstances for companies to assume that the first

exercises were from the first tranche to vest and that subsequently exercised options were from any

remaining options in the first tranche, followed by options in later tranches, in order of vesting.

Regardless of the manner in which the expected term assumption is determined – i.e., by stratifying

the options by tranche or by using a single expected term ─ companies can still avail themselves of the

accounting policy election of either straight-line or graded attribution of the aggregate compensation

cost over the requisite service period for awards with graded vesting and service conditions only.

9.3.10 Other considerations for expected term assumptions

Companies may consider using different volatility assumptions for different intervals of the overall

expected term of an award because volatility may be expected to change over the expected term.

Volatility that is assumed to change over time may also affect exercise patterns. Generally, only the

more sophisticated lattice models can incorporate these relationships. However, when valuing options

it is possible to adjust historical exercise data to reflect the assumption that future volatility will differ

from recent stock-price volatility (see SC 9.4).

The expected term for option valuation may be impacted by the expected dividend yield. Because

employees receiving options generally do not receive dividends on the underlying stock until they

exercise, larger dividends offer an additional incentive to exercise options early. Companies should

therefore consider adjusting the expected term assumption for significant differences between

historical and expected future dividend yields.

Although ASC 718 acknowledges that blackout periods may affect the expected term assumption; it is

rare that contractual or SEC-required blackout periods directly affect early exercise behavior or have a

significant effect on the measurement of options’ fair values. Such periods tend to be fairly short (e.g.,

six months) and, if they recur, will have already been incorporated into the exercise history.

Occasionally, for potential tax advantages, options may be exercisable prior to vesting. The exercise

price is returned to the employee and the award is forfeited if the employee is terminated prior to

vesting. For accounting purposes, this type of exercise is not considered substantive. Therefore, any


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historical analysis of exercise activity should reflect such an exercise as occurring at the vesting date,

for those options that vest, and should exclude from the analysis any options that are forfeited.

9.3.11 Comparing expected term assumptions under different models

Lattice models are generally believed to produce a more refined estimate of fair value than the Black-

Scholes model because they have the capacity to incorporate assumptions that vary over time and over

potential stock price scenarios. Moving from the Black-Scholes model to a lattice model requires

developing more complex assumptions concerning early exercise behavior. Because of the intricacies

involved, lattice models are covered only in summary form in the discussion that follows, using

examples to illustrate some of the considerations involved.

9.3.11.1 Modelling exercise behavior in relation to stock price

Lattice models replace the single expected term assumption of the Black-Scholes model with a set of

assumptions that describe employees’ early exercise behavior. That set of assumptions can range from

a number of simple assumptions (similar to the expected term assumption under the Black-Scholes

model) to an array that correlates the rate at which employees are expected to exercise their options to

varying levels of stock price appreciation, as well as other factors. One typical difference between the

Black-Scholes model and a lattice model is the manner in which a typical termination provision is

handled. Most employee options include a clause that accelerates the contractual expiration of a vested

award to a date 60 to 90 days after termination of employment, regardless of the remaining

contractual term. The post-vesting termination rate is reflected indirectly in the single expected term

assumption in the Black-Scholes model. However, a series of rates that change over the contractual

term is generally a separate set of assumptions in a lattice model.

One approach to implementing a lattice model involves estimating the probability distribution of early

exercise over two variables: the time that has elapsed between the grant date and the exercise date,

and the assumed level of stock-price appreciation at the time of exercise. As described in SC 8.5, this

latter variable is called the suboptimal exercise factor and is usually expressed as a multiple of the

exercise price. Suboptimal exercise factors may (1) be single values, (2) be values that change over the

life of an option, or (3) take the form of probability distributions.

A simple set of assumptions in a lattice model incorporating stock price appreciation is comprised of a

single suboptimal exercise factor and fixed rate of post-vesting cancellations, along with the vesting

period and contractual term of the option. The option would be assumed to (1) be exercised

immediately at any point after vesting when the suboptimal exercise factor is reached; (2) be exercised

on expiration if in-the-money but the suboptimal exercise factor is not reached; and (3) expire

worthless if out-of-the-money.

A more elaborate set of assumptions to be used in a lattice model could involve either multiple

suboptimal exercise factors (and/or post-vesting cancellation assumptions) that change over time, or

probability distributions.

Figure SC 9-2 presents an illustrative distribution of the probability of exercise for an award that cliff

vests after one year of service.


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Figure SC 9-2 Illustration of probability distribution of early exercise

Suboptimal exercise factors

Years after grant

0–1 1–2 2–3 3–4 4–5 5–6 6–7 7–8 8–9 9–10 10

> 3.0 0% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

2.8–3.0 0% 99% 99% 100% 100% 100% 100% 100% 100% 100% 100%

2.6–2.8 0% 98% 98% 99% 99% 99% 100% 100% 100% 100% 100%

2.4–2.6 0% 95% 95% 96% 96% 98% 99% 99% 99% 99% 100%

2.2–2.4 0% 88% 88% 92% 92% 95% 96% 98% 98% 98% 100%

2.0–2.2 0% 79% 79% 84% 84% 88% 92% 95% 95% 95% 100%

1.8–2.0 0% 66% 66% 73% 73% 79% 84% 88% 88% 88% 100%

1.6–1.8 0% 50% 50% 58% 58% 66% 73% 79% 79% 79% 100%

1.4–1.6 0% 34% 34% 42% 42% 50% 58% 66% 66% 66% 100%

1.2–1.4 0% 21% 21% 27% 27% 34% 42% 50% 50% 50% 100%

1.0–1.2 0% 12% 12% 16% 16% 21% 27% 34% 34% 34% 100%

In Figure SC 9-2, the early exercise probabilities are cumulative and correlate with various stock-price

appreciation rates. If the stock price is between 2.0 and 2.2 times the exercise price between two and

three years after the grant date, the model assumes that 79% of the options will have been exercised.

Between three and four years, assuming the stock price remains constant, the proportion assumed to

have been exercised climbs to 84%.

9.3.11.2 Expected term for awards with graded vesting

Typically, a company that offers options with graded vesting features would construct a separate

probability distribution for each vesting tranche because the vesting date—the first date when

exercises can occur—will be different for each tranche. The vesting date is an important input in lattice

models because these models consider the possibility that if the stock price has risen significantly

above the exercise price by the vesting date, it is very likely that employees will exercise their options

immediately upon vesting. By contrast, the estimate of fair value under the Black-Scholes model is

only indirectly affected by the vesting period in that the vesting period affects the expected term

assumption.

Developing a probability distribution like the one shown in Figure SC 9-2 begins with an analysis of

historical exercise data. In addition to elapsed time since grant date, this process considers the effect

of stock-price appreciation on expected exercise. Generally, the early exercise distribution used in a

lattice model will reflect the hypothesis that exercise becomes increasingly likely as the underlying

stock’s price appreciates. If a company does not have historical data to support this assumption, it may

have to use another modeling technique or data from outside sources.

9.3.11.3 Sources of bias and adjustments to historical data

A company using a lattice model should understand its data requirements and the potential sources of

bias in estimating the probability distribution of early exercise. Both Black-Scholes and lattice models


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can use the methods described earlier to address biases arising from an incomplete exercise history.

However, extended periods of consistent upward or downward stock-price movement, lack of relevant

data, historical data that does not fairly reflect future expectations and other factors can affect lattice

models in more complex ways due to multiple assumptions about early exercise behavior and the

addition of stock-price appreciation levels and other variables. For example, distributions of actual

exercises based on recent historical data dominated by periods of extreme stock-price depreciation or

appreciation relative to the prices on the grant dates are likely to overstate or understate how long

employees are likely to hold their options in the future. Adjustments to historical data should be made

in such cases in order to support a lattice model that reasonably reflects future expectations.

Lattice models may require different adjustments than the Black-Scholes model. For example, a

historical stock-price path that was dominated by rapid appreciation (and high levels of early exercise

that often accompany this scenario) might require further analysis and adjustment of the historical

expected term under the Black-Scholes model (as noted in SC 9.3.2), because such rapid stock price

appreciation is not expected to recur. Under the lattice model, the same historical stock price path

might result in suboptimal exercise factors that are too high because simply applying the historical

data to the new grants assumes that the historical stock price path will continue. The assumptions

developed for lattice models will therefore have to be based on careful analysis, including adjustment

for potential biases and mitigation of the impact of data affected by unusual stock price history that is

not reflective of future expectations. Since lattice models typically will require more assumptions than

those used in the Black-Scholes model, more analysis will generally be required to properly develop

assumptions for lattice models.

9.3.11.4 Post-vesting cancellations and suboptimal exercises

Unlike the Black-Scholes model, lattice models treat post-vesting cancellations and voluntary early

exercise behavior as two separate assumptions. Because the options of terminated employees may

often be exercised earlier and at lower levels of stock-price appreciation than the options of employees

who remain, and are typically cancelled without any payoff if they are underwater during the post-

termination exercise period (generally, 60 to 90 days), lattice models can reflect this assumption in

more detail than the Black-Scholes model. The post-vesting cancellation assumption should be based

on the actual behavior of a similar group of employees. In developing the probabilities of voluntary

early exercise for a lattice model (unlike the development of expected term for the Black-Scholes

model), the post-vesting cancellations should be excluded, because they are considered separately.

Thus, when using a lattice model, an analysis should be performed to separate a company’s history of

employee exercise behavior into two categories: voluntary (early) exercise and forced exercise that

results from termination of employment.

A simpler, less refined form of lattice modeling assumes that early exercise occurs 100% of the time

when the stock price first reaches a level represented by a single suboptimal exercise factor. This factor

is normally estimated by analyzing probabilities of early exercise over various historical periods in

relation to stock price appreciation at the time of exercise. It may be necessary to adjust the data for

possible biases due to unusual stock price movements, and there is some inherent unreliability in

using a single exercise factor.

9.3.11.5 Limitations of only company-specific exercise history

Many companies will not have sufficient exercise history or the ability to analyze company-specific

historical data that is necessary to support the exercise distribution assumptions required for lattice

models. A company that decides to use a lattice model may need to hire outside consultants to assist


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with software, develop assumptions, and determine any adjustments necessary to mitigate data biases

and deficiencies.

Finally, lattice models may incorporate other predictors of early exercise. Other variables tied to stock

price performance (besides time and stock price) that may be used in an exercise-prediction model

include recent stock price performance (over various windows) or recent stock price volatility. The

same considerations may be applied when developing early exercise assumptions to be used in a

Monte Carlo simulation model.

9.4 Expected volatility

Developing volatility assumptions is a common practice in the financial community, where many

sophisticated techniques have been developed that go beyond simply calculating volatilities based on

historical stock prices. The Black-Scholes, Monte Carlo, and lattice models all use a volatility input,

which may come from a variety of sources (e.g., historical data, implied market volatility, peer group

volatility).

When using historical data to estimate volatility, a sufficient number of daily, weekly, or monthly

prices should be used to make the subsequently annualized results statistically valid. Because the

estimate of volatility reflects the variation in returns expressed as a percentage of the stock price,

annualized volatilities can be compared across stocks on a normalized basis regardless of how

frequently the prices are measured, length of the measurement period, or the stock prices of the

companies being compared.

Many companies base their volatility assumptions on their historical stock prices, or use historical

volatility as a starting point for setting this assumption under ASC 718. According to ASC 718-10-55-

24, companies should also consider how future experience may differ from the past. This may entail

using other factors to adjust historical volatility, such as implied volatility, peer group volatility, and

the range and mean of volatility statistics over various historical periods.

Because ASC 718 does not endorse a particular method of estimating expected volatility, a company

should consider all available data, including what marketplace participants would likely use in

determining an exchange price for a traded option. When a company develops its volatility assumption

to use in its option-pricing model, it should consider the following alternatives:

□ Historical volatility — a measurement of the amount by which the company’s stock price changes

have fluctuated in the past

□ Peer group volatility — historical volatility developed for comparable companies (typically used if

historical volatility is unavailable)

□ Implied volatility — the assumption implied by the observed current market prices of the

company’s traded options or other convertible securities (if available)

□ Blended volatility — a volatility assumption developed by combining data from various sources

(e.g., historical volatility calculated using different windows, peer group volatility or implied

volatility)

As described in SAB Topic 14, companies should make good faith efforts to identify and utilize

sufficient information in determining whether using historical volatility, implied volatility, or a


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combination of the two will result in the best estimate of expected future volatility. When using a

combination of various estimates, significant judgment is required to determine the relative weighting

of the different measures. ASC 718 does not contain prescriptive guidance related to the weighting of

estimates. According to SAB Topic 14, a company should consider all available information but may,

under certain circumstances, rely exclusively on historical or implied volatility. Furthermore, the SEC

staff “. . . believes companies that have appropriate traded financial instruments from which they can

derive an implied volatility should generally consider this measure.” A company should also disclose in

its footnotes why it used the volatility measure it selected.

9.4.1 Historical volatility

As discussed above, a company may conclude that historical results are the best indicator of the future.

This section discusses the calculation of historical volatility and how to adjust for various

circumstances, such as insufficient data and one-time events.

9.4.1.1 Calculation of historical volatility

Volatility is calculated by taking the standard deviation of continuously compounded historical returns

on underlying stock prices (adjusted to remove shifts on ex-dividend dates) and then annualizing the

result. Volatility is normally annualized by multiplying by the square root of the number of

measurement dates used during a one-year period (e.g., volatility based on weekly prices is annualized

using the square root of 52). An appropriate starting point is to measure historical stock prices with

consistent frequency over the most recent historical period equal to (or greater than) the option’s

expected term (for the Black-Scholes model) or contractual term (for lattice models). Companies

should have a consistent methodology about the length of the historical window used to estimate

volatility, absent relevant changes, such as a significant change in the expected term of options

currently granted. The consistency of volatility over other time windows should also be considered. See

SC 9.4.1.2 for details on whether and how it may be necessary to consider different volatilities over

different terms.

Because volatility usually changes slowly, it may not be necessary to make a separate calculation for

each grant date. Grants might be grouped by interval (e.g., by one or three-month periods) and a

volatility assumption developed for each period, provided that observed shifts in volatility are not

significant. Awards may also need to be grouped and separate volatility assumptions used to reflect

differences in contractual terms and vesting schedules. In addition, if a given historical volatility

window includes short-term volatility that is not expected to occur in the future, companies should

consider whether or not to exclude that data when developing an assumption.

9.4.1.2 Exclusive reliance on historical volatility

After considering all available information, a company may decide to exclusively rely on its historical

volatility, because it believes that its historical volatility provides the most reliable indication of future

volatility. According to SAB Topic 14 (section D.1, question 4), a company may rely exclusively on

historical volatility when the following factors are present, so long as the methodology is consistently

applied:

□ A company has no reason to believe that its future volatility over the expected or contractual term,

as applicable, is likely to differ from its past;

□ The computation of historical volatility uses a simple average calculation method;


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□ A sequential period of historical data at least equal to the expected or contractual term of the share

option, as applicable, is used; and

□ A reasonably sufficient number of price observations are used, measured at a consistent point

throughout the applicable historical period.

The following sections address adjustments that a company may need to consider when developing its

historical volatility assumption, which may lead the company to conclude that exclusive reliance on

historical volatility over the most recent period of time equal to the expected term is not appropriate.

Frequency of historical volatility measurement

The frequency of stock price measurement can significantly affect the expected volatility assumption.

For example, volatility estimates vary depending on whether stock prices are measured on a daily,

weekly, or monthly basis. While differences in annualized volatility estimates due to measurement

frequency differences may be small, this is not always the case.

A high frequency of measurement (e.g., daily stock prices) provides the largest possible sample size, as

discussed in ASC 718-10-55-37(d). According to that paragraph, a public company “would likely use

daily price observations.” On the other hand, it also may be appropriate to use lower frequency data

(e.g., monthly), provided there is an adequate sample size.

ASC 718 does not provide detailed guidance on adequate sample sizes for computing historical

volatility. SAB Topic 14, footnote 56, indicates that monthly data should not be used for periods

shorter than three years due to insufficient data, indicating that more than 36 data points should be

used to estimate historical volatility when using monthly data. Footnote 64 of SAB Topic 14 suggests

that two years of daily (approximately 500 measurements) or weekly (approximately 100

measurements) data could provide a reasonable sample, though daily data may be more appropriate

when there is an expected term shorter than two years.

When volatilities calculated based upon different measurement intervals (e.g., daily, weekly and/or

monthly) differ significantly, a company may consider averaging the annualized volatility estimates

from the different measurement intervals. When an option’s expected term is much shorter than the

available history or when there is less history available, generally it would be more appropriate to use

an estimate based on daily or weekly data in order to assure an adequate sample, assuming daily or

weekly prices are available and that sufficient trading occurs on each day to make these quotes reliable

market indicators. Regardless of which measurement frequency is selected, it should be used

consistently for all awards.

Insufficient historical stock price data

Some companies do not have historical stock prices that can be reliably determined for a period that is

at least equal to the expected term of their options or do not believe that their recent historical

volatility fairly reflects future expectations (e.g., a company that has been public for only three years

and has estimated the expected term of its options to be five years). In such cases, it may be

appropriate to blend the company’s own volatility data with that of a peer group of public companies.

Companies in the peer group should (1) be of similar size, (2) have similar histories and relatively

comparable financial leverage, and (3) be in similar businesses (industry and geographical markets).


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Peer-group volatility

To compute peer-group volatility, a company should use data from one or more relatively recent

historical periods that are at least as long as its expected term. Though various weightings are possible,

volatility data from the peer group companies are usually averaged, with each company given equal

weight.

If a company that grants options with a five-year expected term is looking to use peer-group data to

supplement its own last three years of historical data, it would be appropriate to obtain peer-group

data for the two years preceding the past three years. In this way, the historical period would equal the

five years of the expected term. The company could give the peer-group’s average volatility for the two

earliest years a two-fifths weighting and its own historical volatility three-fifths. In other fact patterns,

other weightings of peer company and company-specific volatilities may be appropriate. A company

generally should avoid using overlapping periods of data in this type of analysis (e.g., averaging the

peer-group data over the full five-year window with the company’s three-year historical data), because

that approach would unevenly weight certain periods (see the section below on Mean-reversion and

term structure of volatility).

Newly public companies

SAB Topic 14 also allows newly public companies (i.e., those that recently filed for an IPO, whether or

not the IPO has yet occurred) to base their estimates of expected volatility on the historical, expected,

or implied volatility of similar companies whose stock or option prices are publicly available, after

considering the industry, stage of life-cycle, size, and financial leverage of the other companies.

A newly public company can develop peer-group volatility using some of the companies listed in an

industry sector index (e.g., a computer vendor may look to a NASDAQ Computer Index, if there is

one). However, the company may not use the volatility of the index itself as a substitute. The newly

public companies should use the companies selected from the industry sector index consistently,

unless circumstances change, or until it has either a sufficient amount of historical information

regarding the volatility of its own stock price or other traded financial instruments become available to

derive an implied volatility to support an estimate of its expected volatility.

Nonrecurring events

SAB Topic 14 and ASC 718 cite other instances when it may be appropriate to adjust historical

volatility for past events that a marketplace participant would likely discount, such as a discrete event

that is not expected to recur (e.g., failed takeover bid or major business restructuring). Historical data

demonstrably affected by such events (e.g., the abnormally high volatility observed in the six-month

period leading up to or following a significant transaction) might be reasonably excluded from the

historical volatility calculation, provided the event is specific to the reporting company, under

management’s control, and not expected to recur during the expected term of the award. However,

question 2(s) in Section D.1 of SAB Topic 14 indicates that such exclusions are expected to be rare.

One-time events may also lead to increased expected volatility as compared to unadjusted historical

volatility. For example, if a company recently announced a merger that would increase its business risk

in the future, then it would consider the impact of the merger in estimating its expected future

volatility if it is reasonable that a marketplace participant would also consider this event.


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In the rare situations when nonrecurring events such as those described above imply that historical

data may not be representative of the future, a company may simply exclude stock-price data from the

affected period(s) and use the remaining history so long as there remains sufficient historical data to

make an estimate. Companies should carefully analyze volatility estimates from periods that include

breaks to ensure that those gaps are not treated as market-price movements. In some cases, such as

when the excluded period is an extended period of time, a company may consider using a blended

estimate that incorporates peer-group data for the excluded period.

Some companies may be tempted to exclude historical volatility data caused by extraordinary market

conditions, such as the effects of the credit crunch in 2008 and the COVID-19 pandemic. We generally

believe that data should only be excluded when the volatility relates to one-time events specific to the

reporting company that are reasonably within the control of the company’s management or

shareholders. Data related to events affecting the broader market should not be excluded from a

company’s analysis, even when those events are considered extremely unlikely to recur. In addition,

data from periods of significant stock price changes over a short period of time, such as may occur due

to lawsuits, failed product trials, or recalls, generally should not be excluded.

Mergers, acquisitions, divestitures and changes in financial leverage

The volatility of a merged company may differ from either predecessor, while a spin-off may affect

volatility of the new entity and its former parent. With merged companies, each of which represents a

major component of the merged entity, typically a weighted average of the two entities’ historical

volatility is appropriate, with the volatility of each company weighted by relative market capitalization

prior to the transaction. Spin-off companies will probably have to use peer-group data to estimate

volatility, and their former parent may have to do the same if the spin-off fundamentally changes the

parent.

Lastly, financial leverage needs to be considered as a factor in examining historical volatility. If a

company’s debt-to-equity ratio has shifted dramatically over recent history whether due to a merger,

spinoff, or just re-leveraging, consideration of other data points such as peer group information may

be appropriate.

Mean reversion and term structure

A statistical phenomenon referred to as mean reversion occurs when a series of values is more likely to

move towards its longer-term mean than away from it. Volatility is often observed to be cyclical,

moving between temporary or short-term highs and lows but then reverting back to the long-term

average. Therefore, if a stock’s price has been extraordinarily volatile for the past year when compared

to a longer period, it may be reasonable to assume that, within another year, the stock price volatility

will begin to migrate toward its longer term average volatility level. Under these circumstances, the

long-term volatility assumption for options granted in the next year might fall between that of the

more volatile recent period and the less volatile long-term average. The mean-reversion theory would

also apply when recent volatility has been extremely low compared to long-term average volatility.

Companies should consider mean reversion when significant cyclical swings in volatility are observed

in the historical data.

Term structure refers to how historical volatilities may vary over specific intervals. This may be

relevant in determining the volatility assumptions over the option’s expected term (or contractual

term when a lattice model is used). The justification for incorporating term structure into an estimate

of expected volatility would ordinarily be based on mean-reversion. Thus, if last year’s volatility was


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20%, but average annual volatility over the previous five years was 40%, the annual volatility

assumption for each of the next five years might be closer to 20% at the beginning of the expected term

and eventually move toward 40%. An explicit term structure approach to the expected volatility

assumption might be used in a more refined lattice model instead of a single fixed volatility

assumption, where exercises and vested cancelations are assumed to occur not just after a single

weighted average expected term, but throughout the option’s entire contractual life. However, the

mean-reversion concept may also be applied to a single-value volatility forecast input into the Black-

Scholes model.

Mean reversion will generally be most applicable in developing the volatility assumption when

expected term is relatively long and recent short-term volatility is very different from long-term

average historical volatility. In practical terms, applying the concepts of mean reversion and term

structure to expected volatility assumptions involves looking for evidence of possible mean reversion

by examining volatility over at least two historical periods of varying lengths, assuming a company has

the data. According to ASC 718-10-55-37(a)(2), a company using the Black-Scholes model should start

with a period equal in length to the option’s expected term, then use progressively shorter periods to

determine whether there is a pattern of changing volatility (though longer periods may be examined as

well).

If consistent volatility experience is exhibited by using periods of varying lengths, or if actual

experience exhibits no clear pattern over various sub-periods of the historical period that corresponds

with the option’s expected term, then it may be more appropriate to use an unadjusted volatility

estimate based on data from a consistent historical period equal to or greater than the length of the

expected term. While mean reversion may not be apparent in the historical data based on periods

shorter than the expected term, companies should also consider whether it applies on a longer time

scale. A company that has typically used five-year volatility for an award with a five-year expected term

might also consider data over seven- and ten-year windows, as well as over periods shorter than five

years. If the five-year volatility appears unusual, using a blend with longer-term data may be more

appropriate. However, using data that is too old (much longer than the typical contractual terms of ten

years) is likely to be less relevant and not the best predictor of expected volatility.

It may be difficult to assess whether changes in volatility relate to mean reversion or are due to specific

circumstances, such as a company’s growth, diversification, reorganization, merger, or spin-off.

Careful examination of year-by-year volatility in this context compared to volatility measured over the

entire expected term may be helpful in assessing whether a mean-reversion adjustment is appropriate.

9.4.2 Implied volatility

As discussed above, a company may need to consider adjusting its historical volatility when developing

its expected volatility assumption. After analyzing its data, a company with available implied volatility

information may conclude that its historical results are not the best indicator of the future and instead

consider blending implied volatility with historical volatility or, in some cases, relying solely upon

implied volatility.

Implied volatility is based on the market price of a company’s exchange-traded financial instruments and

is sometimes thought to be a market forecast of a company’s future stock price volatility. Because current

market trades may suggest more about a company’s future stock prices than its historical volatility,

many believe implied volatility is superior to historical volatility as a tool for predicting future stock

price volatility. In our experience, implied volatility tends to correlate with shorter-term historical

volatility levels and therefore may be more applicable to shorter-term than to longer-term forecasts.


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Generally, we do not expect companies to solely use current short-term implied volatility as their best

estimate of long-term volatility for measuring the fair value of employee stock options.

9.4.2.1 Calculating implied volatility

It can be difficult to use implied volatility for valuing employee options because most implied

volatilities are based on traded financial instruments (e.g., exchange-traded options) with substantially

shorter terms than those of employee stock options. Typically, exchange-traded options have terms

less than one year. A select group of large companies have long-term traded options called LEAPs that

have terms of two to four years, but other companies have only exchange-traded options with terms

less than eighteen months, and many companies have no exchange-traded options at all. Thus, the

expected term for most of a company’s employee options is much longer than the contractual terms of

exchange-traded options on the company’s stock. Exchange-traded options are also often thinly

traded, so reliable price quotes may be lacking even when option terms are comparable.

To calculate implied volatility, a company should use the Black-Scholes model to find a volatility input

that makes the fair value of an employee stock option equal to the market price of the exchange-traded

option on a specific date. Because exchange-traded options—unlike employee stock options—are

generally held for their full contractual term, there is no judgment involved in estimating their

expected term. It simply equals the remaining contractual term of the exchange-traded option on the

specific date. Options embedded in certain forms of traded convertible debt may also be used to

determine implied volatility.

One pragmatic approach to deciding whether implied volatility is stable enough to rely upon is to

perform at least several measurements using the longest duration, market-traded, at- or near-the-

money options to ensure that the calculated implied volatilities remain reasonably stable. If the

volatilities do not appear stable, they should either not be used as the sole determinant of the volatility

assumption (even if the length of the remaining contractual life of the exchange-traded options and

the expected term of the employee options are comparable) or they should be weighted less than

historical volatility when using a blended rate.

9.4.2.2 Exclusive reliance on implied volatility

SAB Topic 14 provides additional guidance on determining when and how to use implied volatility.

According to SAB Topic 14 (Section D.1, question 4), a company may, in limited circumstances, rely

exclusively on implied volatility. Based on that guidance, the SEC staff will not object to exclusive

reliance on implied volatility if all of the following criteria are met and the methodology is consistently

applied:

□ The company’s valuation model is based on a constant volatility assumption (e.g., Black-Scholes

model).

□ Implied volatility is derived from options that are actively traded.

□ Market prices (i.e., trades or quotes) of both traded options and underlying shares are measured

concurrently, synchronized with the grant of the employee stock options. If this is not practicable,

a company should at least derive implied volatility as of a point in time that is as reasonably close

as practicable to the grant of the options.


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□ Traded options have exercise prices that are (1) near-the-money and (2) similar to the exercise

prices of employee stock options.

□ The remaining maturities of the traded options are at least one year.

The term “actively traded” is not defined in SAB Topic 14; however, Rule 101(c) of SEC Regulation M

provides criteria (average daily trading volume of $1 million and a public float value of at least $150

million) that may be used by analogy to determine if sufficient trading volume meets this condition.

Based on the guidance in SAB Topic 14, a company could potentially use the implied volatility of an

exchange-traded option with a remaining term of one year to estimate the expected volatility of an

employee stock option with an expected term longer than one year. In determining whether and to

what extent the use of implied volatility is appropriate under these circumstances, companies should

consider (1) the other factors from SAB Topic 14, (2) how much longer the expected term of the

employee option is than the remaining contractual life of the exchange-traded options, and (3) the

historical comparability of implied volatility levels with longer-term observed historical volatility

experience. Companies should also note that implied volatilities themselves often vary widely over

time relative to observed volatilities calculated using long-term historical prices. Therefore, only

implied volatilities measured within a few weeks prior to the measurement date should be considered.

9.4.3 Blended volatility

Using a blend of historical and implied volatility may be appropriate in the following circumstances:

□ A company meets some, but not all, of the SAB Topic 14 required conditions to exclusively rely on

historical or implied volatility,

□ the term structure of implied volatility is unstable, or

□ the expected term of the option is significantly greater than the contractual term of traded options.

A combination of both volatility measures may provide the best estimate of expected volatility because

it captures the mean reversion concept by weighing both historical (longer term) and implied (near

term future) volatilities, and offers the most flexibility to adapt to a company’s specific facts and

circumstances. We believe this approach is consistent with how most marketplace participants would

likely consider using available information to estimate expected volatility, as illustrated in Example SC

9-1.

While SAB Topic 14 stresses that a company’s process to gather and review available information to

estimate expected volatility should be consistently applied, if facts and circumstances change to

indicate new or different information may be useful in estimating expected volatility, then a company

should incorporate that information. Situations occasionally arise in which shifts in methodology will

be necessary (for example, when previously-used historical or implied information is no longer

available or has changed greatly in its apparent reliability). Any such change is not a change in

accounting policy, but must nevertheless be supported by sound rationale that the new or different

information produces a better estimate of expected volatility. This would include a change in the

relative weightings of contributory sources of information—for example, switching from a 50%/50%

average of historical and implied volatility, to either a 100% historically-based estimate or a 100%

implied-based estimate.


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Example SC 9-1 illustrates an approach of using available information from multiple data sources to

estimate expected volatility.

EXAMPLE SC 9-1

An approach for estimating volatility using multiple data sources

In early 20X4, Company A acquired Company B in a stock transaction. Company A’s stock has

historically been much more volatile than Company B’s. However, from the transaction’s

announcement to its closing date, Company B’s shares have become much more volatile, moving in

tandem with Company A’s shares since late 2004. Once the deal closed, the combined company’s

shares became less volatile, closer to Company B’s pre-announcement historical volatility levels.

On January 1, 20X7, the combined company issues employee stock options. Because this was a

significant acquisition and it has only three years of data as a combined company, Company A also

looked at peer-group volatility data for the post-acquisition period. During this time, historical one-

year volatilities for the peer-group of companies were consistently below the historical one-year

volatility of the combined company.

Pre-acquisition volatilities of the separate companies based on weekly prices were as follows:

Year Company A Company B Average of Company

A and Company B

20X1 65.4% 33.8% 49.6%

20X2 77.3% 43.3% 60.3%

20X3 69.7% 71.1% 70.4%

The post-acquisition volatilities for Company A and its peer group were as follows:

Year Combined company Average peer group

20X4 56.5% 48.1%

20X5 53.8% 45.8%

20X6 39.3% 33.5%

Three-year historical volatility 50.8% 43.3%

Most recent two-year historical volatility 48.0% 39.0%

Management believes that each company’s volatility was elevated during the year prior to the

acquisition (20X3) and the combined companies’ volatility was elevated during the year after the

acquisition (20X4) due to the market’s uncertainty about the integration of the two companies.

The volatility of exchange-traded options on the combined company’s shares was also assessed for

dates near the end of December 20X6. These traded options have contractual terms of four to eight

months. Management excluded information on thinly traded options from its analysis and used three


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specific options that have larger trading volumes, believing that their implied volatility is reliable. The

specific options included in management’s analysis were near-the-money at the end of 20X6.

The implied volatilities calculated from the traded options are lower than the historical volatilities of

either the predecessor companies or of the peer group:

Trade date Remaining term (as of trade date) Implied volatility

December 28, 20X6 8 months 32.4%



Average 31.2%

Average (excluding four-month option) 31.1%

How should management use this data to develop an expected volatility assumption for the options

granted in early 20X7 with a three-year expected term, a ten-year contractual term, and a one-year

cliff-vesting service condition?

Analysis

Because the company uses the Black-Scholes model, it would develop a single volatility estimate for

the options’ expected term, beginning with the combined company’s three-year historical volatility of

50.8%.

Assuming the combined company does not envision an acquisition of this magnitude in the

foreseeable future, it may expect near-term future volatility to be much lower, perhaps as low as the

20X6 level of 39.3%. The consistently lower peer-group volatilities from 20X4 to 20X6 appear to

support this assumption.

However, if management believes that the combined company has unique features that might affect

future performance, the average volatility that its own stock experienced in the last two years (48.0%

over 20X5 through 20X6) may be a more reliable basis for a historical volatility forecast than the peer-

group data, and is not inconsistent with the average of Company A and Company B volatilities of

55.0% in 20X1 and 20X2.

Management should also consider the much lower implied volatilities of its traded options. These

appear to show that market expectations regarding near-term future volatility are considerably below

historical levels. However, the traded options have terms of less than a year, while the employee stock

options have expected terms of three years. Consistent with ASC 718 and SAB Topic 14, management

should consider all of the above factors when estimating its expected volatility estimate, weighting the

historical and implied volatility. Given that the only available exchange-traded options with remaining

contractual terms to expiration greater than 6 months have a total term of only eight months

(compared to the employee options’ term of 3 years), a relatively lower weighting for the implied

volatility would be reasonable. Assume this results in a 37.5% weighting for the implied volatility and a

62.5% weighting for the two-year historical volatility.


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Using these percentages to weight the average implied volatility for traded options with eight-month

terms and the company’s own two-year historical average yields the following blended volatility

estimate:

(Implied average × weighting) + (Historical average × weighting) = Expected

(31.1% × 37.5%) + (48.0% × 62.5%) = 41.7%

Company A would use this weighted average as the expected volatility assumption in determining the

fair value of its new employee stock options.

This example is intended to illustrate the potentially relevant data points in developing a volatility

estimate and one potentially appropriate approach. The determination of volatility is a matter of

judgment and will vary depending on each specific set of facts and circumstances. For example, the

historical three-year-average peer-group volatility of 43.3% was not used directly but helps

corroborate the reasonableness of the applied approach. Also, the company could have considered

peer group implied volatility.

9.4.4 Comparing volatility assumptions under different models

The Black-Scholes model uses a single volatility estimate over an option’s expected term. In contrast,

lattice models can incorporate dynamic volatility assumptions that vary over the option’s contractual

term, along with more sophisticated assumptions where volatility changes with stock-price

fluctuations.

In Example SC 9-1, the combined company’s averaged volatility estimates considered both its own and

peer-group historical periods of varying lengths and near term implied volatility to arrive at a single

expected volatility estimate for the Black-Scholes model. A lattice model could incorporate a period-

by-period future expected volatility in different parts of the lattice rather than a single combined

volatility forecast. This also means that a longer historical period might become relevant, since the

lattice model should simulate the entire contractual term of the option, not just its expected term.

9.5 Risk-free interest rates

Both the Black-Scholes and lattice models require the use of risk-free interest rates.

9.5.1 Risk-free interest rates in the Black-Scholes model

The risk-free interest rate assumption involves less judgment than the other assumptions required in

an option-pricing model. In the US context, the Black-Scholes model typically makes use of the

implied rate on the grant date for a traded zero-coupon US Treasury instrument with a term equal to

the option’s expected term. Zero-coupon bonds are used because they have one payment that will be

paid at the end of the expected term to match the period of investment through the time until expected

exercise or settlement of the award. For terms greater than one year, Treasury STRIPS should

generally be used. However, other estimates of risk-free rates are available (such as swap curves) and

may be appropriate. Companies outside the US or companies issuing options with exercise prices

denominated in a foreign currency should use an appropriate risk-free instrument in that currency

environment in developing a risk-free rate assumption, or may use forward currency exchange rates


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combined with US risk-free rates. If an option’s expected term or an equity award’s contractual term

falls between two maturities with available risk-free rate data, it is usually appropriate to interpolate a

rate from the available maturities.

Implied interest rates on zero-coupon government bonds are based on their traded prices. These are

typically reported as bond-equivalent yields based on implied semi-annual compounding (this allows

one to compare zero-coupon and coupon-bearing government bonds which make payments semi-

annually). To obtain precise results, a company should convert bond-equivalent rates into

continuously compounded rates before using them in the Black-Scholes model. Although the

difference is usually very small, a company that wishes to omit this step should determine whether the

difference is material.

9.5.2 Risk-free interest rates in lattice models

Lattice models require risk-free interest rates for all potential durations until exercise. These rates are

obtained by using a yield curve for the relevant instrument as of the grant date. A lattice model will

therefore require the yield curve for the entire time period during which employees might exercise

their options. Some software packages specify the frequency with which users should input yields over

the potential exercise period (e.g., monthly), while others allow users to choose the frequency with

which they input a range of yields. These risk-free interest rates are often different in coupon type and

compounding frequency from those reported in the financial media. Users should be careful to

determine the proper type of rate to input into the modeling software to achieve a zero coupon risk-

free rate in the valuation.

9.6 Expected dividend yields

Both the Black-Scholes and lattice models require an assumption for expected dividend yields.

9.6.1 Expected dividend yields in the Black-Scholes model

Selecting the expected dividend yield assumption usually does not require extensive analysis. A

common practice is to assume that current dividend yields or cash dividend payments in effect at the

grant date will continue in the future. The dividend yield assumption is usually determined (1) by

dividing the most recent dividend paid by the current stock price, or (2) as an average of one or more

recent dividend payments divided by the stock price on their respective declaration dates. These

methods work if dividend yields are expected to remain reasonably stable and, if so, may be used with

the Black-Scholes model without further adjustment. Higher dividend yields reduce the fair value of

options; lower dividend yields increase the fair value of options.

A company with highly volatile stock prices and relatively stable cash dividend payments may find that

dividend yields are also volatile. Such companies may have to use a longer history to obtain a

reasonable estimate of future dividend yield. For example, a company whose quarterly dividend

remains at $0.10 per share, while its stock price trades regularly between $20 and $40, will find that

its historical yield fluctuates between 1% and 2%. This company could estimate its dividend yield over

a longer period (e.g., the option’s expected term) while considering the effect of recent stock-price

changes up to the grant date on expected future yields.

When a company has had a pattern of increasing or decreasing dividend yields, and this pattern is

expected to continue, it may be appropriate to reflect this pattern in the expected dividend yield


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assumption. For example, a company with a history of significant and steady increases in cash

dividend payments might indirectly forecast a continuation of those increases regardless of future

changes in the stock price by using a slightly higher dividend yield assumption. If the estimated

increases are large enough, an option pricing model reflecting a forecast of increases in cash dividend

payments may result in a lower fair value than an otherwise similar model reflecting the historical

percentage dividend yield. A model reflecting a percentage dividend yield assumes the percentage

yield remains constant (i.e., dividends in the future will change in proportion to changes in stock

price), whereas a forecast of steeply increasing cash dividends may result in higher future dividend

yields and therefore, a lower fair value.

In a case where a company recently experienced a significant change in stock price, without a

comparable change expected in future dividend amounts that would maintain the company’s average

historical dividend yield levels, it may be appropriate to consider only current and/or near term future

expected dividend amounts (annualized) compared to the stock price on the grant date, when

determining the expected dividend yield assumption. Because under the standard Black-Scholes

model stock prices are expected to increase in the future on average at the risk-free rate of return, this

basis for determining the dividend yield for use in the Black-Scholes model would also be appropriate

for companies that have a consistent pattern of gradual annual dividend increase in the amount of

cash dividends without regard to increases or decreases in stock price.

9.6.2 Expected dividend yields in lattice models

The usual adaptation of the Black-Scholes model for dividend-paying stocks uses a single dividend

yield estimate, which is input as a percentage of the stock price with that yield held constant as a

percentage of stock price over the expected term of an option. Lattice models have been adapted to

reflect dividends, which are assumed to be specific fixed-dollar amounts, as an alternative to using a

constant dividend-yield forecast. The assumed cash dividend payments may be further assumed in a

lattice model to change over an option’s contractual term (e.g., continuing a pattern of steady increases

or decreases). These models also allow for explicit input of changing dividend yields or amounts over

different periods. Lattice models can simulate the fact that, in certain circumstances, employees may

be expected to exercise slightly earlier than they otherwise would, specifically timing exercises in order

to capture a large dividend payment. This may result in a further reduction in fair value (under a

refined lattice model as compared to a Black-Scholes model) for options on stocks that pay large

dividends.

9.6.3 Dividend-protected awards

Generally, option holders are not entitled to receive dividends that are paid on the underlying shares

of an option or other equity award. Certain stock options or other equity awards may be structured to

provide option holders a form of dividend protection. For example, an option may be structured so

that the exercise price is adjusted downward during the term of the option to reflect dividends paid on

the underlying shares. Dividend protection features should be reflected in the estimate of the fair value

of the stock option. Where the exercise price is reduced by an amount equal to the per-share dividend

payments made on the underlying shares, the effect of the dividend protection may often be

reasonably approximated by using an expected dividend assumption of zero and the unadjusted grant

date exercise price in the option pricing model. Other types of dividend protection, such as the

payment of nonrefundable cash dividend equivalents to holders of unexercised options or unvested

awards may result in somewhat larger effects. Companies should assess the impact of other features

on the fair value of the stock option, considering the form of dividend protection provided. See SC 2.9

for guidance on the accounting treatment of cash dividend payments received by award holders.

Chapter 10: Stock-based compensation plan design considerations

Stock-based compensation plan design considerations

10-2

10.1 Stock-based compensation plan design overview

This chapter is intended to assist companies and the designers of stock-based compensation plans in

better understanding the key issues that are likely to affect how stock-based and cash-based long-term

incentive plans are designed. It addresses developments that may impact stock-based compensation

and plan design as well as certain tax considerations related to an employee’s taxable income and

employer deductions.

10.2 The executive compensation environment

In designing an executive compensation plan, companies consider how their decisions will impact the

employee, the company, and market perception. Different internal and external economic and

accounting factors may influence a company’s decision to offer stock vs. cash incentives, for example,

or the nature of the conditions required to be met to earn the incentive. Each decision may result in

differences in the timing and amount of related expense recognized by the company and have tax

consequences for the company and the employee. Companies should consider each of the following

factors when developing or making changes to its compensation plans.

10.2.1 Restricted stock – plan design

Institutional investors and their advisors have consistently expressed concern that significant use of

restricted stock provides too much benefit to employees who have only limited downside potential

(i.e., it provides employees with value even if the company’s stock price declines) and creates excessive

costs for shareholders. It is important for companies to strike the right balance on the use of restricted

stock to incentivize employees while protecting shareholder value.

10.2.2 Performance conditions – plan design

As discussed in SC 2.5.1, ASC 718 defines market conditions, performance conditions, and service

conditions as factors affect the exercisability or vesting of stock-based compensation awards. For

purposes of compensation design, the general term “performance” (e.g., performance conditions or

performance shares) typically refers to any non time-based vesting or exercisability condition included

in an award. Therefore, companies may use the term “performance shares” to refer to either a market

condition or a performance condition under ASC 718. The use of a “performance condition vesting

requirement” has both tax and accounting consequences. As such, designing a performance condition

may require input from human resources, tax, and finance personnel.

IRC Section 162(m), discussed in SC 10.8.1, provides that a public company cannot deduct

compensation that it pays to its top officers (“covered employees”) if the compensation exceeds $1

million per year. Prior to the 2017 tax law changes, certain performance-based compensation was

exempt from this limitation. Under new law, that exception no longer applies and therefore all

compensation paid to one of the covered employees will be subject to the limitation. Additional

changes expand the scope and duration of covered employee status. A limited transition relief rule

may grandfather deductibility for compensation provided pursuant to a written binding agreement

that was in effect on November 2, 2017 and is not materially modified thereafter.


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10.2.3 Corporate governance - plan design considerations

Shareholders, institutional investors, and regulators continue to scrutinize executive compensation

and demand “pay for performance” and executive accountability. They may question whether stock-

based compensation, and specifically options, cause executives to make decisions primarily to drive

short-term increases in stock price instead of what is in the company’s best long-term interest. In

response, many companies actively engage in discussions with shareholders and proxy advisors on

equity compensation program design, results and disclosures and describe the nature and outcome of

these discussions in their proxy statement. In some cases, stakeholder feedback may influence

management to redesign their compensation plans, alter grant practices, and enhance disclosures

related to their plans. Changes to better align plan design and stakeholder interests may include

extending the vesting schedules, setting mandatory holding periods, establishing guidelines for net

share retention, and adding clawback provisions in the event of certain “bad behaviors”.

10.2.4 Clawbacks of stock-based compensation awards

The Sarbanes-Oxley Act included provisions that called for clawbacks of CEO and CFO compensation

in the case prior period financial statements had to be restated. Many companies have “noncompete”

clawbacks, which require an employee to return some amount of compensation if he or she leaves to

work for a competitor. Other actions that commonly trigger clawbacks include fraud, malfeasance, and

the violation of a nonsolicitation agreement (prohibiting a former executive from recruiting other

employees for their new employer).

The Dodd-Frank Act requires national security exchanges to require any listed company to include

clawback provisions in their incentive compensation plans for current and former executive officers.

The clawback provision must indicate that, in the event of certain accounting restatements, the issuer

will recover the excess of what was paid over what would have been paid to executive officers based on

the restated amounts during the 3-year period prior to the restatement. The provision applies to cash-

based incentive compensation programs as well as stock-based compensation arrangements. This

requirement is broader than the clawback provision in the Sarbanes-Oxley Act, which permits the SEC

(but not the company or its shareholders) to recoup monies for the company from only the CEO and

the CFO extending back 12 months, and is applicable only in cases involving the restatement of the

financial statements caused by misconduct.

The SEC proposed regulations to implement the Dodd-Frank requirement, but they have not been

finalized. Even so, many companies have enhanced their employment contracts to allow for clawbacks

in the event the executive:

□ Engages in conduct that is detrimental to the company;

□ Takes actions that result in restatement of the financial statements or other financial harm to the

company;

□ Achieves performance-based targets, although expected profits were not actually achieved when

considered in hindsight;

□ Violates established risk management policies, considered from both a quantitative and qualitative

perspective; and


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□ Demonstrates behavior that, in the discretion of management or the compensation committee, is

improper.

These clawback provisions are intended to help companies better align compensation and risk.

However, there are a number of challenges in implementing clawbacks. Because some of these

clawback provisions are vague, it may be difficult to determine whether they have been triggered. In

addition, even when a provision has clearly been triggered, it might not always be clear who triggered

it. For example, if a company needs to restate its financial statements, it might not be obvious whether

the clawback would apply only to the individual who directly caused the restatement, or should also

apply to that person’s supervisor who failed to catch the error.

As discussed in SC 2.4, the accounting guidance for many clawbacks is generally straightforward.

However, the new breed of clawback features may pose accounting challenges. For example, some

provisions may require stock-based compensation awards to be clawed back if certain operating or

performance metrics are not met. Because such provisions are linked to the performance of the entity

or individual, they would likely be considered "performance conditions" for accounting purposes. The

accounting for awards with performance conditions is different from the accounting for awards with

clawback features. Further, the company may need to determine whether those measures will be based

on the performance of individuals, business units, or subsidiaries. Assessing performance at the

individual level may seem like the fairest approach, and it is certainly possible in some cases (e.g., for a

trader in a financial services firm). In many cases, however, tracking such measures may be impossible

or cost-prohibitive.

The accounting for clawbacks presumes the company and employee mutually understand the key

terms and conditions of the clawback feature when the award is issued. A grant date may not be

established at the time of issuance of the award if there is subjectivity or discretion regarding the

triggering event of the clawback feature. If there is no grant date, variable (i.e., mark-to-market)

accounting may be required (if a service inception date is established) for the fair value of the award

until settlement or the date that a mutual understanding of the terms and conditions is reached.

To ensure that these performance-type clawback features will result in the establishment of a grant

date at inception, the metrics should be clear and objectively determinable. Conditions based on the

operations of the employer must be based on metrics that are established up-front at the grant date.

These metrics might be based on financial metrics (e.g., revenue, earnings, or EPS targets), operating

metrics (e.g., number of accounts opened, new customers or loans signed), or specific actions of the

company (e.g., change in control, IPO).

Conditions based on the employee's individual performance will also need to be clear and objective. If

metrics are based on employee evaluations and performance ratings, the evaluation process should be

well controlled and understood by the employee, be reasonably objective, and serve as a basis for

promotion and other compensation decisions.

Some companies provide themselves discretion to claw back compensation awards. This discretion

might be related to the contingent event itself (i.e., what triggers the clawback), or to the consequence

of the clawback (i.e., what action will the company take as a result of the clawback). This discretion

may result in an inability to establish a grant date for accounting purposes upon award issuance, as a

grant date can only be achieved when the employer and employee mutually understand the key terms

of the award. If the company has discretion to decide when a clawback is triggered, the employee may

not be in a position to understand what is required in order to earn and retain the award.


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Finally, since clawbacks entail recovering compensation that has already been awarded, enacting a

clawback may result in litigation.

10.2.5 Executive compensation disclosures

The Dodd-Frank Act requires companies to describe in their proxy statement the relationship between

executive compensation actually paid and the company’s financial performance, which is measured by

an issuer’s Total Shareholder Return (TSR) and TSR relative to peer companies. A need to compare

actual pay and financial performance may cause companies to rethink their compensation structures

and may incent them to include graphical presentations that demonstrate the relationships between

actual pay and performance in various elements of compensation in their CD&A. Companies may also

wish to consider reviewing performance metrics to assess the degree to which existing program

incentives support the increased emphasis on TSR as a measure of performance.

10.2.6 Taxation of stock-based compensation awards

The tax impact of stock-based compensation awards to both employees (see SC 10.6) and employers

(see SC 10.7 and SC 10.8) is a significant consideration in plan design. As discussed in SC 10.10, the tax

law determines when an employee is taxed for certain awards such as discounted stock options and

stock appreciation rights (“SARs”). Under IRC Section 409A, these awards are taxed on the date of

vesting, even if they have not yet been exercised, and a 20% federal penalty is assessed in addition to

regular income tax. In addition, every year after vesting until the option is exercised is another taxable

event for the employee. Such treatment can easily result in a 75% tax rate and it is difficult to calculate

the taxes due and figure out how to withhold taxes from employees, which is required. As a result, few

companies knowingly grant discounted stock options or SARs to employees.

10.3 The role of stock awards in compensation plan design

Stock options, restricted stock, and other long-term incentives are critical components of effective

compensation programs—in fact, the majority of companies grant at least one, if not a combination of

these vehicles to select employee levels.

Figure SC 10-1 summarizes the accounting, tax and plan design considerations for the major categories

of employee stock-based compensation awards.

Figure SC 10-1 A primer on stock-based-compensation awards

All awards are presumed to be equity-classified except for the cash-settled SAR and phantom stock

At-the-money stock options (non-qualified) with service condition

Incentive stock options (qualified)

Discounted stock options

Premium options

Stock-settled SAR

Cash-settled SAR

Restricted stock or restricted stock units (RSUs)

Performance shares with performance conditions

Description Stock option with exercise price equal to stock price at grant date, vests based on

Same as nonqualified at-the-money stock option except for special tax treatment if

Stock option with exercise price less than stock price at grant date

Option with exercise price set higher than grant date stock price

Employee receives stock equal to intrinsic value at exercise; otherwise identical to

Same as stock-settled SAR except intrinsic value at exercise paid in cash

Grant of shares (restricted stock) or promise to issue shares (RSUs) upon

Restricted stock or units that vest based on time-based vesting plus attainment of


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Premium options

Stock-settled SAR

Cash-settled SAR



continuous employment over specified time period

the option complies with IRC requirements

nonqualified stock option; may be at-the-money, discounted or premium exercise price

completion of service condition

non-stock-price-related performance conditions (e.g., revenue or EPS)

Pros Employee benefits from stock price increases; can be issued to employees and directors; simple to understand; provides more ‘upside’ potential than restricted stock

Same as nonqualified at-the-money option except employee may receive capital gain treatment instead of being taxed as ordinary income

Same as at-the-money option except provides reward even if stock price declines somewhat; employee may perceive that discount has more value than increase in fair value

No value to employee unless stock price rises above premium; increases motivation; reduces fair value

Same as nonqualified stock option plus exercise price need not be paid by employee, and reduces dilution compared to broker-assisted exercise

Same pros as stock-settled SAR except for accounting under ASC 718 and no share dilution

Simple for employees to understand; provides value if stock price declines; less share usage as compared to stock options

No expense unless performance target attained; employee motivated to reach targets; shareholders also benefit if targets reached

Cons Has no ‘downside’ risk if stock price declines below exercise price; may not provide optimal linkage with business, compensation and shareholder objectives

Same as nonqualified at-the-money stock options; employer generally has no tax deduction unless disqualifying disposition; can only be issued to employees; no tax benefit recorded for accounting purposes until exercise and a disqualifying disposition

Unfavorable tax treatment for employee under IRC Section 409A

Employee may demand more options to make up for perceived reduction in value

Same as nonqualified stock options

Mark-to-market accounting; otherwise same as nonqualified stock options; requires use of cash

Provides less value than options if stock price rises; may be viewed as a giveaway by shareholders

Difficulty in calibrating performance condition

Accounting under ASC 718

Expense based on fair value at grant and number of options that vest, recognized over service period

Same as nonqualified at-the-money stock options; no tax benefit recorded for accounting purposes until exercise and a disqualifying disposition

Same as nonqualified option; fair value higher than at-the-money stock options but generally increase is less than discount amount

Same as nonqualified at-the-money stock options except lower grant-date fair value


Considered liability award with mark-to-market fair value (using an option-pricing model); total expense equals cash paid to employee

Expense based on grant-date fair value of stock and number of shares that vest, recognized over service period

Same as restricted stock except recognize compensation cost over the period when targets will probably be attained and true-up for actual vesting


10-7




Premium options

Stock-settled SAR

Cash-settled SAR



US taxation Employee: Subject to income and employment taxes based on intrinsic value (difference between stock price and exercise price) at exercise

Employer: Deduction equal to employee’s income

Employee: No employment taxes; no tax at exercise (other than AMT); subject to capital gains tax at sale of shares (may have ordinary income if a disqualifying disposition occurs)

Employer: Deduction equal to employee’s ordinary income; no deduction unless disqualifying disposition

Employee: Under IRC Section 409A, discounted options treated as deferred compensation with employee taxed at vesting and 20% penalty applied Employer: Deduction equal to employee’s income

Same as nonqualified at-the-money stock options



Employee: Subject to tax at vesting based on stock price on that date; may elect under IRC Section 83(b) to be taxed at grant date. RSU’s may allow for further deferral opportunities

Employer: Deduction equal to employee’s income when taxed

Same as restricted stock

Performance shares with market conditions

Options with performance conditions

Awards with vesting accelerators

Indexed option

Reload options

Maximum value options

Phantom stock

Description Same as performance shares with performance conditions except with targets related to stock price increases or relationship of stock price to an index

Stock option that vests based on attainment of performance condition

Options or restricted stock with time-based vesting where vesting accelerates if specified targets are attained, (performance or market condition is attained)

Options with exercise price that increases (or decreases) at regular intervals, either by fixed percentage, reference to published index or peer group stock price changes

Grant of new options, subject to same expir-ation date as original option, for shares of owned stock used in option exercise

Stock option with cap on maximum level of appreciation (e.g., two times exercise price)

Grant of hypothetical stock units (full value or appre-ciation only) equivalent to shares of stock. Units generally valued based on a formula and employee receives cash upon exercise or vesting

Pros Employee directly motivated to increase stock price; fair value per share generally lower than stock price at grant

Same as performance shares except have greater upside potential of an option

Increase employee motivation to achieve targets

Same as premium options if exercise price only increases; exercise price could drop (e.g., when peer group prices fall) then employees may be rewarded for doing better than peers

Locks in stock price appreciation for employee but retains value of future appreciation

Reduced compensation expense with little or no reduction in employee’s perceived value

Simple to understand


10-8

Performance shares with market conditions

Options with performance conditions

Awards with vesting accelerators

Indexed option

Reload options

Maximum value options

Phantom stock

Cons Compensation expense not reversed if targets not attained; lattice model generally required to measure fair value

Same as performance shares except no protection against reduction in stock price

Targets may be outside employee’s direct control; retention value lost once targets are reached

More complicated to understand and administer; fair value complex to calculate; shareholders may question why employees are rewarded when stock price declines

May ultimately have higher compensation expense

Caps upside potential value; hard to explain to employees; generally requires lattice model

Mark-to-market accounting if settled in cash

Accounting under ASC 718

Fair value at grant-date reflects market condition using lattice model; expense recognized over derived requisite service period and not reversed if targets are not attained

Same as performance shares with performance condition

For awards with performance condition, see performance shares with performance conditions. For awards with market conditions, see performance shares with market conditions

Generally needs a lattice model to measure fair value; cross-volatility assumption may be needed; otherwise accounting same as at-the-money stock options; could be a liability if index is something other than stock price

Same as nonqualified options with reload treated as new grant; original grant and each reload may have short expected term assumption, reducing fair value and expense

Same as at-the-money stock options except fair value lower due to cap; generally need lattice model to measure fair value

Same as cash-settled SAR

US taxation Same as restricted stock

Same as nonqualified options

Same as options or restricted stock


Same as nonqualified options with reload treated as new grant


Employee: Subject to ordinary income tax.

10.3.1 Costs and benefits of stock-based compensation plans

Companies should attempt to estimate the perceived value to their employees of a stock-based

compensation plan and compare that perceived value to the fair value determined under ASC 718.

According to academic research and empirical data, there may be a significant gap between the cost, as

measured in accounting terms, and the perceived value to the employee of a stock-based

compensation award. Some of the more prominent observations are:

□ Academic research finds that the cost of stock-based compensation to a company (fair value) often

exceeds what participants perceive to be the value of stock-based compensation, due to factors

such as lack of diversification, non-transferability, and risk aversion.

□ Research further indicates that the cost/benefit gap increases for lower level employees because

those employees are less able to bear the increased risks (i.e., lack of diversification) associated

with stock-based compensation.

□ Generally, the cost/benefit gap also increases proportionally to the extent that the stock-based

compensation is out-of-the-money (e.g., the gap is narrowest for at-the-money options and widest

for underwater or premium-priced stock options).


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□ In one study, observed trades of cash for stock-based compensation confirmed that the fair value

of the stock-based compensation in such trades exceeded the value of the cash compensation that

was replaced (e.g., $12,000 of stock-based compensation was required to replace $10,000 of cash

compensation).

□ Surveys of employees’ preferences can be used to better understand the perceived value of

alternative forms of stock-based and cash compensation. Perceived value is a temporal notion that

hinges on current economic and market factors.

10.3.2 Practical implications of ASC 718 on plan design

When designing a long-term incentive plan, a company should consider the following steps:

□ Estimate the fair value and compensation cost associated with each alternative design.

□ Ascertain employee preferences regarding different forms of stock-based compensation (e.g., use

focus groups, employee surveys, etc.) to estimate the cost/benefit relationship of alternative

strategies.

□ Develop plan designs that balance share usage/dilution, tax deductibility, deduction timing, the

effective tax rate, compensation cost, cash flow, earnings per share and administrative costs.

□ Re-evaluate the total compensation mix (e.g., cash vs. equity) to optimize value for total

compensation cost.

□ Introduce performance targets in stock-based compensation plans, particularly for senior

executives and assess implications of market versus performance conditions.

□ Develop methodologies to compare different forms of compensation for external benchmarking

and internal purposes.

□ For non-US employees, make sure that new plan designs maximize tax deductibility in all

jurisdictions.

□ Determine the administrative requirements and costs of new plan design.

□ Evaluate communications strategies.

□ Reconsider the range of long-term incentive eligibility within the organization.

□ Provide differentiation in grants to reward high performers and/or employees with higher

retention risk.

10.4 Plan design process: An expanded set of constituents

To address the requirements of ASC 718, tax planning, and other considerations on plan design, most

companies need to draw on an array of subject matter experts. The cross-function plan design teams

have the responsibility for creating, documenting, and benchmarking alternative plan designs and

presenting those alternatives for management and compensation committee approval.


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Prior to the adoption of the guidance in ASC 718, most companies’ planning teams consisted primarily

of human resources staff, who were responsible for overseeing executive compensation, with separate

involvement by the legal department and limited involvement by members of the finance and tax

departments. Subsequent to the adoption of the guidance in ASC 718, companies have needed to

expand the role that members of the legal and finance departments play on the plan design team and

encourage a greater degree of participation and coordination among team members. If business-

performance metrics are to be used in future stock-plan awards (e.g., for vesting), the team probably

needs to also include operations and business unit managers.

Figure SC 10-2 summarizes the roles of the members of a company’s plan design team.

Figure SC 10-2 Typical roles of corporate departments in designing long-term incentives

Department Typical roles

Stock plan administrator/ human resources

Chairs the team; develops competitive stock plan and benchmarking data for long-term incentives; recommends eligibility rules; recommends the types and amounts of long-term incentive awards; advises on the general competitiveness of the company’s plan in the market; coordinates with business units on correlating stock plans to business strategy, selecting the metrics, and targeting performance levels; coordinates employee surveys and communications

Finance Determines the financial feasibility and impact of implementing, modifying, and using long-term incentive compensation plans (considers a range of issues from accounting costs to shareholder dilution to cash flow implications); provides (through payroll department) compensation information that is to be included in the proxy statement; involved in the valuation and reporting of awards

Tax Determines the tax liabilities and benefits of long-term incentive compensation for the employer and employees (for both US and foreign employees); assists with the design, modification, implementation, and use of the various types of long-term incentive compensation awards; coordinates compliance with income tax accounting rules under ASC 718 and 740; advises on IRC Section 409A deferred compensation rules; advises on IRC Section 162(m) rules

Investor relations Assesses major investors’ views on plan design and share-allocation requirements; coordinates (with the human resources and legal departments) necessary shareholder approvals

Legal/corporate secretary

Ensures compliance with laws and regulations during the design, modification, implementation, and use of long-term incentive compensation plans; drafts the plan; coordinates (with the human resources department) proxy disclosure requirements; prepares compensation committee resolutions

Boards of directors’ compensation committees are also becoming more involved in the overall design

process, which culminates in the plans being approved by the committee and the full board of

directors. Compensation committees are often engaging independent compensation consultants to


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review proposed plans and provide guidance to the committee as it makes its final decision. Many

companies will become more proactive in considering the views of their key shareholders and

shareholder advisers when designing stock-based-compensation plans and are advised to disclose

sufficient information about newly designed plans to ensure that shareholders understand the plan’s

objectives and operation. In addition, the board’s audit committee should oversee the financial

reporting, disclosure, and valuation issues related to ASC 718. Finally, CD&A and SEC executive

compensation proxy disclosure rules require extensive reference to ASC 718 calculations, including

reference to the assumptions used to estimate fair value.

10.5 Employee stock purchase plans (ESPPs)

Under ASC 718, ESPPs generally result in compensation cost. A company may wish to continue

operating its ESPP as currently designed, regardless of the compensation cost, to provide its

employees with the maximum benefit. Because the compensation cost associated with an ESPP

(including the discount and fair value related to the look-back provision) are incurred only for

employees who voluntarily participate, the overall compensation cost of an ESPP may be lower than

initially expected. This is in contrast to broad-based stock option grants that result in cost for all

recipients, regardless of whether those recipients view the options positively. However, a company that

wants to reduce its ESPP compensation cost should consider the following alternatives:

□ Making the ESPP’s discount comply with ASC 718’s safe-harbor discount of 5% and eliminating

the look-back provision (results in no charge).

□ Keeping the discount at historical levels and eliminating the look-back provision (results in a

reduced charge).

□ Eliminating the discount and keeping the look-back provision (results in a reduced charge).

□ Eliminating multiple-period ESPP plans or those with a reset provision for the look-back price

(results in a reduced charge).

□ Some companies are swapping the company-stock-purchase-option in their 401(k) plans and

replacing it with an ESPP. This initiative reduces the company’s fiduciary risk related to the

401(k), while still offering employees with an option to invest in company stock (thus mitigating

any negative perceptions associated with the company-stock purchase removal from the 401(k)). It

also provides an additional corporate tax deduction opportunity for dividends paid on stock held

in the plan.

See further discussion of the accounting for ESPP’s in SC 5.

10.6 Income tax considerations — Employee’s taxable income

The following section summarizes some of the key individual income tax considerations related to

stock-based compensation under US federal income tax laws and regulations. It is intended to provide

helpful context for considering plan design from the employer perspective. However, it is not intended

to be and should not be considered comprehensive authoritative guidance for any specific employer or

employee tax consequences.


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10.6.1

10.6.1.1

10.6.1.2

Basic rules for employees’ taxable income

An understanding of how employees are taxed for stock-based compensation in the US requires

knowledge of the underlying principles of deferred compensation: the principles of economic benefit

and constructive receipt. Application of these principles, together with certain statutory provisions

(described in SC 10.6.1.1), determines when a taxable event occurs and the amount that should be

taxed.

Economic benefit and constructive receipt

The economic benefit doctrine specifies that when an employer transfers property to an employee,

such as shares of restricted stock or an economic benefit in cash or property (e.g., the funded and

secured right to receive cash in the future), the employee’s receipt of that cash or property should be

taxed immediately unless the transfer is subject to a substantial risk of forfeiture.

The constructive receipt rules govern the timing of an employee’s inclusion of compensation, such as a

stock-based compensation award, in taxable income. As a general rule, a cash-basis individual

taxpayer is taxed when the individual receives an item of income. However, income that is not actually

received (or deemed to have been received under the economic benefit doctrine) will be taxed if it has

been constructively received. Income is constructively received when the income is set aside, credited

to, or made available so that the individual may draw upon it at any time without substantial

limitation or restriction. IRC Section 409A partially codifies the constructive receipt rules but does not

alter or affect the application of any other IRC provision or common law.

Together, the doctrines of economic benefit and constructive receipt provide a framework for

determining when stock-based compensation awards will be included in the employee’s taxable

income. However, in the vast majority of situations, statutory provisions specifically dictate how those

doctrines apply to stock-based compensation awards. The IRC (including IRC Section 83, discussed

further in SC 10.6.1.2) specifically addresses the most common stock-based compensation awards,

including restricted stock, restricted stock units, nonqualified stock options, and statutory stock

options. Those awards are described in SC 10.6.2, SC 10.6.3, SC 10.6.4.1, and SC 10.6.4.2.

IRC Section 83

Generally, stock-based compensation will be taxed under IRC Section 83, which requires that property

(such as shares of stock) that is transferred to an employee or independent contractor will be taxed as

ordinary income at the earlier of when the property is transferable by the employee or is not subject to

a substantial risk of forfeiture. Shares of stock are considered property; however, neither cash nor an

unfunded and unsecured promise to pay is considered property. A transfer of property occurs when an

employee acquires a beneficial ownership interest in the property.

If an employee receives the benefits and risks of holding the property, generally the employee is

considered to have beneficial ownership and a transfer to the employee has occurred within the

meaning of IRC Section 83.

Property is transferable by the employee (and therefore taxable to the employee) if (1) the employee

receiving the award can sell, assign, or pledge (such as for collateral for a loan) his or her interest in

the property and (2) the employee is not required to give up the property or its value in the event the

substantial risk of forfeiture materializes. A substantial risk of forfeiture is a condition which if not met

can result in a forfeiture of the property. Whether a risk of forfeiture is substantial depends upon the


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facts and circumstances. The most common risk of forfeiture is the risk that the employee will fail to

meet a requirement to continue to perform services for the employer during a specified period (i.e., an

employee’s failure to fulfill a service condition) or that designated performance or market conditions

are not met. Treasury Regulation Section 1.83-3(c)(2) describes other situations that may result in a

substantial risk of forfeiture, as well as provides examples of conditions that do not cause a substantial

risk of forfeiture.

10.6.1.3 Section 83(i) “qualified stock” deferrals

As a result of the 2017 Tax Cuts and Jobs Act, qualified employees of certain private companies may

elect to defer tax for up to five years after the exercise of stock options or the settlement of RSUs

(“qualified stock”), with the taxable value locked in at exercise or settlement. This election is not

available with respect to any current or prior CEO or CFO, any 1% shareholder, the top four officers

during the preceding 10 years, or any relatives of such persons. If the entity is no longer a private

company (such as through an IPO) or the stock otherwise becomes transferable (including back to the

company), the deferral period would end.

10.6.2 Restricted stock awards - tax implications to employees

In a typical restricted stock award, the employer gives the employee, or allows the employee to

purchase, shares of the employer’s stock. As discussed in SC 1.3, ASC 718 also refers to restricted stock

as unvested or non-vested shares. While the employee is considered the owner of the restricted stock

for purposes of state law, the employee’s right to the stock is generally subject to a substantial risk of

forfeiture and generally cannot be transferred until the service, performance, or market condition

associated with the award is satisfied. If the specified condition is not satisfied during the award’s

requisite service period, the employee will forfeit the stock and return the shares to the employer.

Because the employee’s right to the restricted stock cannot be transferred and is subject to a

substantial risk of forfeiture, the employee will postpone including the restricted stock in taxable

income until the right becomes transferable or the risk of forfeiture lapses or expires, whichever occurs

first.

Once the substantial risk of forfeiture lapses (i.e., vesting occurs), the employee recognizes

compensation (i.e., ordinary) income equal to the fair market value of the restricted stock on the

vesting date less any price the employee has paid for the stock (i.e., the intrinsic value). For stock of a

publicly traded corporation, the fair market value of restricted stock equals the traded market price of

a similar unrestricted share of the same class of stock. The employee’s income from the restricted

stock will be subject to federal income tax, employment taxes, and potentially state and local taxes.

Thereafter, the employee’s tax basis in the stock is the fair market value of the stock on the vesting

date; the employee’s holding period for capital gains purposes begins immediately after the vesting

date.

Once the employee is vested, the employer must report the income to the IRS on a timely basis, and

also withhold the applicable taxes. As a result, employees should be prepared to sell sufficient shares

or have cash available to pay the withholding taxes. Alternatively, if the employer permits, employees

may choose to have the employer withhold shares with a value equal to the required withholding taxes.

Employers that withhold shares (often referred to as a net settlement) should carefully review the

accounting implications of this withholding alternative. As described in SC 3.3.6, if an employer

withholds an amount that exceeds the employee’s maximum statutory rate in a jurisdiction, the stock-

based compensation award would be classified as a liability under ASC 718.


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10.6.2.1

10.6.2.2

10.6.2.3

A service recipient (i.e., a company who engages an independent contractor) must report to the IRS

compensation paid to independent contractors. There is no required withholding unless the backup

withholding rules apply.

Capital gains tax on restricted stock awards

Upon selling the vested shares, the employee will recognize a capital gain or loss on the difference

between the sale price and his or her basis in the shares. The tax treatment will depend on how long

the employee holds the shares before disposition. If the employee holds the shares for more than one

year and the price exceeds the tax basis of the shares, the gain will be taxed as a long-term capital gain.

If the employee holds the shares for one year or less, the gain will be taxed as a short-term capital gain.

The employee may also be subject to state and local taxes on the gain depending on where the

individual works and resides.

IRC Section 83(b) elections on restricted stock awards

An IRC Section 83(b) election enables an employee to pay income tax on the fair market value of

property such as a restricted stock award on the date it is transferred (e.g., the date it is granted)

rather than on the vesting date, as required under the normal rule of IRC Section 83(a). Thus, an IRC

Section 83(b) election effectively means that the employee ignores the substantial risk of forfeiture

provision in an award or believes that the risk of forfeiture is not significant. An IRC Section 83(b)

election does not, however, change the requirement that the employee satisfy the vesting condition. If

the employee fails to satisfy the vesting condition, the award will still be forfeited.

Any appreciation in the restricted stock after the grant date will be taxed as a capital gain (either long-

or short-term) instead of as ordinary income with the capital gains holding period commencing at the

date of grant instead of the vesting date. The employer will be required to withhold applicable taxes at

the grant date, and the employee will have to make arrangements with the employer to satisfy the

withholding requirements. The result of this election for stock that appreciates in value after the grant

date is a reduction in the taxes that the employee incurs. Conversely, if the stock declines in value, the

employee is limited to a capital loss upon sale of the stock.

Employees should be aware that an IRC Section 83(b) election is not without risk. For example, if the

employee does not satisfy the vesting condition, the award will be forfeited and the employee will not

be allowed an ordinary loss (but may recognize a capital loss) with respect to any amounts actually

paid for the stock but not on the income recognized under the IRC Section 83(b) election. The

employee also bears the risk of a market decline between the grant date and the vesting date.

An IRC Section 83(b) election must be filed no later than 30 days after the grant of the restricted stock

award and, once filed, is irrevocable. The election must be filed with the IRS service center where the

employee normally files his or her tax return. The employee no longer must attach a copy to the tax

return for the taxable year in which the election is made.

Dividend treatment on restricted stock awards

If dividends are paid on restricted stock during the vesting period, the dividend income will be treated

as compensation income and will be subject to the reporting and withholding rules described in SC10.6.2.1 (i.e., ordinary income to the employee). Once the restricted shares are vested, the dividends

will receive normal dividend treatment and will not be subject to the withholding rules that apply to

compensation income. If the employee makes an IRC Section 83(b) election, dividends received on the


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restricted stock will be treated as regular dividends during the vesting period. Employers should

coordinate with their transfer agent and/or stock-plan administrator to avoid duplicate or incorrect

reporting of dividends on restricted stock.

10.6.3 Restricted stock units - tax implications to employees

Similar to restricted stock, an RSU is an incentive designed to reward an employee with employer

stock provided the specific vesting condition is met. However, unlike restricted stock, an RSU is

merely a promise to deliver stock at some future date as defined by the terms of the award. There is no

transfer of shares on the grant date and no asset for employees to establish either legal or economic

ownership of during the vesting period. Employees do not have voting or dividend rights until the

shares are transferred and there is no opportunity to make an IRC Section 83(b) election at the grant

date because RSUs constitute a promise to deliver property in the future – not an actual transfer of

property at the grant date.

After an RSU becomes vested, the number of shares under the vested RSU is transferred to the

employee on a fixed date or a fixed event (often on the vesting date). IRC Section 83(a) provides that

the employee will have compensation income on the transfer of vested shares equal to the FMV of the

stock on the transfer date less any amount paid by the employee.

Under IRC Section 409A, RSUs are considered deferred compensation and must comply with IRC

Section 409A or result in an additional 20% federal tax penalty to the recipient, additional

underpayment penalties, and an acceleration of taxation to the vesting date. Refer to SC 10.10 for

further discussion of IRC Section 409A.

RSUs that are settled at the time of vesting must be structured to either comply with IRC Section 409A

or satisfy the short-term deferral exception. Some RSU plans have a deferral feature, under which the

employer delivers the shares in a year later than the year of vesting or allows employees to voluntarily

postpone receipt of the shares past the vesting date. Any deferral beyond the vesting date must comply

with the IRC Section 409A rules.

There are a number of non-US jurisdictions that tax restricted stock at the grant date rather than the

vesting date. Multinational companies that wish to convey a similar economic benefit while deferring

tax until the actual receipt of the shares should consider granting RSUs rather than restricted stock.

Prior to granting restricted stock and/or RSUs, multinational companies should review the tax laws of

each jurisdiction.

10.6.3.1 Dividend equivalents on RSUs

Typically, employees do not receive voting or dividend rights on RSUs until delivery of the shares.

However, an employer may choose to pay dividend equivalents on its RSUs prior to vesting or deliver

the cumulative dividend equivalents on the vesting date. Dividend equivalents, if paid, will be treated

as compensation income and are subject to the normal reporting and withholding rules for

compensation.

10.6.4 Stock options - tax implications to employees

In the US, two types of stock options are generally offered to employees: nonqualified stock options

and incentive stock options (ISOs). Nonqualified stock options are extremely flexible, allowing the

employer to grant options to employees and non-employees, and set the term of the options for


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periods of more than ten years. However, nonqualified stock options generally result in the employee’s

taxable income being included on the option’s exercise date. ISOs, on the other hand, are generally not

taxable to the employee until the underlying common stock is sold, but they must meet certain

statutory requirements in order to qualify for such favorable tax treatment.

IRC Section 409A somewhat limits the flexibility of nonqualified stock options. Under IRC Section

409A, a nonqualified stock option must meet the following requirements: (1) be granted on stock that

is “service recipient stock,” (2) have an exercise price that is (or could be at some point in the future) at

least equal to the stock’s fair market value on the grant date, and (3) not defer the employee’s income

tax to a date after exercise of the option. If these criteria are not met, the option generally will be

considered to be deferred compensation and therefore will be subject to the provisions of IRC Section

409A, including the potential for a 20% penalty tax (refer to SC 10.10 for additional information). A

dividend equivalent right provision may also cause the nonqualified stock option to fail to meet the

criteria. ISOs, qualified ESPPs, and restricted stock awards (but not RSUs) are specifically excluded

from the definition of deferred compensation under IRC Section 409A.

10.6.4.1 Nonqualified stock options - tax implications

In general, most nonqualified stock options granted to employees do not have a readily ascertainable

fair market value. Thus, the employee is not deemed to have received compensation for tax purposes

on the grant date. Such options will be taxed at exercise, assuming the options are vested at that time.

If the options are not vested at the time of exercise (i.e., “early exercise”), the employee would

normally be taxed at the time those shares subsequently vest, similar to restricted stock awards (SC

10.6.2). However, an employee could make an IRC Section 83(b) election in this situation (SC

10.6.2.3), thereby including the value of the unvested shares (less the option exercise price) in taxable

income when the option is exercised.

Like the US, most foreign jurisdictions tax stock options at the time of exercise. However, some foreign

jurisdictions tax the employee at a time other than the exercise date, for example, at grant or at the

time of vesting. Some jurisdictions allow the employee’s tax to be deferred until the stock is sold, so

long as certain conditions are satisfied (similar to what is allowed by the rules governing ISOs in the

US; see SC 10.6.4.2). Multinational companies should understand the tax rules that apply to option

awards to employees in all of their jurisdictions to understand the effect on employee behavior and the

company’s compliance obligations.

If an employee purchases shares or exercises an option using a loan from the employer and the

employee is not required to repay all or part of the loan or if the loan is not adequately secured, the

purchase or option exercise generally is not treated as a transfer of the underlying shares for tax

purposes. Rather, it is treated as a new option or an extension of the existing option to purchase the

shares and the taxable transfer is delayed until the loan is repaid. If the transaction is treated as a

purchase of the shares and the loan is forgiven, the forgiven debt should be treated as compensation

and subject to income and employment taxes. The employer must withhold taxes on the value of the

forgiven debt and report the amount as compensation income. Further, if in making a loan the

employer does not charge interest at the prevailing rate, interest will be imputed and the employee will

be liable for income tax and applicable employment tax on the imputed income. However, in the case

of below-market loans, the employer will not be required to withhold employment taxes and report the

amount of the imputed income if the underlying value of the loan is $10,000 or less.

Not only might a loan feature result in additional unintended tax consequences for the employee and

employer, it also presents potential corporate-governance issues. The Sarbanes-Oxley Act places


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restrictions on direct and indirect personal loans to certain executives. Under Section 402 of the

Sarbanes-Oxley Act, “Enhanced Conflict of Interest Provisions,” it is unlawful for a company to

directly or indirectly provide credit or arrange for the extension of credit in the form of a personal loan

to or for any director or executive officer. Employers should also consider whether their cashless-

exercise program may be affected by this rule (refer to SC 3.3.7 for more information on this type of

program). Loans can also result in a number of accounting issues as described in SC 2.3.

10.6.4.2 Statutory stock options - tax implications

There are two kinds of statutory stock options: ISOs and options that are granted under a qualified

employee stock purchase plan (“ESPP”). Like nonqualified stock options, both types of statutory stock

options are contractual promises that permit an employee to acquire the employer’s stock on a future

date under terms established on the grant date. However, because ISOs and ESPPs meet specific IRS

requirements, they are not taxed on either the grant date or the exercise date (or purchase date in the

case of qualified ESPPs). Instead, employees are taxed when they sell their shares. If the employee

completes a qualifying disposition, whereby the employee sells the stock at least two years after the

grant date and one year after the date of exercise or purchase (the statutory holding period), the

employee will recognize a greater capital gain and less ordinary income on the sale of the stock. If the

employee sells the stock before the statutory holding period ends, the sale will be a disqualifying

disposition and the employee will recognize more ordinary income, which is taxed at a higher rate.

Employment taxes (FICA) will not be due for either ISOs or ESPP shares.

10.6.4.3 Incentive stock options - tax implications

In addition to complying with the statutory holding-period requirement, an option must also satisfy

the following conditions in order to qualify as an ISO:

□ ISOs may be granted only to employees. For purposes of the ISO rules, the term “employee”

has the same meaning as it does in the withholding tax rules of IRC Section 3401(c). Thus, outside

directors and other independent contractors may not be granted ISOs.

□ ISOs plans may not last longer than ten years and an option exercise period cannot

be longer than 10 years from grant. Options under the plan must be granted within ten years

from the date that the plan is adopted or approved by shareholders, whichever is earlier. Although

the term of the plan is ten years, all ISOs may have up to 10 years for exercise, so that even an ISO

granted in the ninth year of a plan may have a ten-year term (5 years for a 10% shareholder).

□ ISOs must have a FMV exercise price. The exercise price cannot be less than 100% of the fair

market value of the stock at the grant date (110% in the case of options that are granted to

shareholders that hold 10% of the company’s stock). A reasonable, good-faith method may be used

to determine the fair market value. If it is determined that the exercise price is less than the fair

market value of the stock on the grant date, the option cannot be treated as an ISO and will be

considered a deferred compensation arrangement subject to IRC Section 409A.

□ ISOs must be exercised within three months of an employee’s termination. If

termination results from disability, ISO treatment may continue up to one year following

termination. If an employee dies and the ISO is transferred by bequest or inheritance, the option

may continue to be treated as an ISO for its full term. An ISO can specify a shorter exercise period

if desired.


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□ Only a limited number of ISOs may be granted. Not more than $100,000 worth of ISOs,

valued at the grant date, may become exercisable in any year for an individual employee. Any

stock options granted that exceed the $100,000 vesting limit will be treated as nonqualified stock

options. This limit applies on an aggregate basis to all ISO plans of the employer, its parent, and

subsidiaries awarded to an individual employee. While the assessment is initially made at the time

of grant, it should be re-assessed as needed, for example if a change in control accelerates vesting

of ISOs.

□ The ISO plan must be approved by the company’s shareholders within one year after

the plan is adopted. The approved plan must specify the aggregate number of shares that can

be issued and the eligible class or classes of employees that may participate in the plan.

□ ISOs may only be granted on the employer’s stock. ISOs cannot involve a partnership

interest.

□ ISOs cannot be transferred. The option agreement should specifically state that the ISOs

cannot be transferred, other than through a will or by the laws of descent.

If an employee sells the shares obtained from the exercise of the option through a qualifying

disposition, the individual will pay only long-term capital gain taxes on sale proceeds that exceed the

option’s exercise price. Although an employee does not recognize taxable income until the shares are

sold or otherwise disposed of, the employee will have to make an adjustment to reflect the alternative

minimum tax (AMT) in the year of exercise. The excess of the fair market value of the shares at

exercise over the exercise price is included in the calculation of the taxpayer’s AMT as a tax adjustment

item. This adjustment is not required if the shares are sold in the same year as the option is exercised.

If an employee fails to meet the statutory holding-period requirements (i.e., if the employee sells the

shares within two years after the grant date or one year after the exercise date including via a net share

settlement), the ISOs will be deemed as having been disposed of in a disqualifying disposition. In a

disqualifying disposition, the exercise of the option will be treated as though the option was a

nonqualified stock option. Even though employment taxes will not be due, ordinary income tax will be

imposed on the stock’s fair market value on the exercise date less the exercise price.

If the amount realized on the sale exceeds (or is less than) the sum of the amount paid for the shares

and the amount of income recognized on the disqualified disposition, the gain (or loss) is determined

under the rules of IRC Section 302 or 1001, as applicable.

The employer is not required to withhold income tax on any portion of the ordinary income or capital

gain that is triggered upon disposition; however, the employer is required to report the compensation

income on the employee’s Form W-2.


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10.6.5 Employee stock purchase plans - tax implications

ESPPs allow employees to purchase company stock (usually via a payroll deduction) at a discount that

does not exceed 15%. For purposes of federal income tax, this discount does not result in immediate

compensation, provided that the statutory holding period requirements and the requirements of IRC

Section 423 are met. For a plan to qualify as an ESPP, it must meet the following requirements:

□ ESPPs may only be offered to employees of the employer or related corporations.

□ ESPPs must be granted to all employees on an equal basis.

□ ESPP shares may be purchased only by an individual who is an employee from the grant date to

three months before the purchase date.

□ An employee who has voting power that is greater than 5% may not participate in the plan.

□ Certain employees may be excluded from participating in an ESPP, including

o Employees who have been employed for less than two years.

o Employees who customarily are employed 20 hours or less per week.

o Employees who customarily are employed no more than five months in a calendar year.

o Highly compensated employees, as defined in IRC Section 414(q).

Because ESPPs must be granted to all employees of US companies to qualify for favorable treatment

under IRC Section 423, multinational companies should generally be careful not to exclude those

employees who work for overseas branches or representative offices of US companies.

ESPPs must also comply with the following conditions:

□ The plan is approved by the shareholders of the company within 12 months before or after the plan

is adopted.

□ The plan designates the aggregate number of shares that may be issued.

□ The awards granted under the ESPP are in the stock of the employer.

□ The term during which a participating employee has the option to purchase the employer’s stock

cannot exceed 27 months, unless the option price is not less than 85% of the stock’s fair market

value at the time that the option is exercised.

Further, an employee cannot accrue a right to purchase more than $25,000 (valued at the grant date)

of stock each year under any ESPP of the employer, its parent company, and subsidiary corporations.

If the ESPP designates a maximum number of shares that may be purchased by each employee during

the offering, or establishes a fixed formula to determine that number (such as $25,000 divided by the

fair market value of the stock on the first day of the offering period), the first day of the offering period

is deemed the “option grant date.” Establishing this date is critical to avoiding issues under IRC


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Section 409A. If no maximum is set, the option grant date for purposes of establishing the minimum

exercise price is deemed to be the exercise date.

In the case of a qualifying disposition, if an option has an exercise price that takes advantage of the

IRC Section 423 discount feature, the employee must include in ordinary income, at the time that the

stock is disposed (assuming that the statutory holding-period requirement is met), the lesser of the

following two amounts:

□ The amount of the fair market value of the shares at the time of the disposition or the employee’s

death that exceeds the exercise price of the option.

□ The amount of the stock’s grant-date fair market value that exceeds the option’s exercise price.

Any additional gain upon selling the stock should be treated as a long-term capital gain.

If the stock is sold through a disqualifying disposition, the employee will recognize ordinary income

that is equal to the difference between the purchase date fair market value and the purchase price. This

amount is considered ordinary compensation income in the year of sale even if no gain is realized on

the sale. The difference between the proceeds of the sale and the employee’s basis in the stock will be

treated as a capital gain or loss. Ordinary income that the employee recognizes upon a disqualifying

disposition of ESPP shares constitutes taxable income and should be reported by the employer on the

employee’s Form W-2; however, taxes do not have to be withheld.

Unlike ISOs, ESPPs provide that even in a qualifying disposition some amount of ordinary income will

be recognized at the time of sale. However, the amount of ordinary income in a qualifying disposition

is generally lower than the amount of ordinary income in a disqualifying disposition.

10.7 Employer’s income tax deductions for stock-based awards

The following section summarizes some of the key corporate income tax considerations related to





Most areas of the income tax laws and regulations can be overwhelmingly complex and rule-driven. It

should therefore come as no surprise that an employer’s reporting of income tax deductions for stock-

based compensation is a complicated matter. This section reviews the income tax rules for employers

that companies commonly need to address when they design or modify their stock-based

compensation plans. The following guidance should be considered a summary, not an all-inclusive

description. Because the rules that govern employers’ reporting of income tax deductions continue to

evolve, companies should monitor the legislation and IRS regulations for new developments.

See TX 17 for a discussion of the financial accounting implications of income taxes associated with

stock-based compensation.


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10.7.1 Employer’s income tax rules for stock-based awards

As discussed in the preceding section of this chapter regarding employee’s taxable income, IRC Section

83 provides guidance on the taxation of stock-based compensation to the employee. IRC Section 83

also specifies how an employer should deduct stock-based compensation on its tax return. IRC Section

83(h) provides that upon the transfer of property in connection with the performance of services, the

“person for whom services were performed” (i.e., the employer) may claim a corporate tax deduction

under IRC Section 162. The amount of the employer’s tax deduction should equal the amount that was

included in the gross income of the person who performed the services (this includes both employees

and nonemployee service providers). If the employer timely reports the income on the employee’s

Form W-2 or on Form 1099 for independent contractors, (1) the person is deemed to have included the

compensation in gross income and (2) the company may deduct the compensation on its tax return.

The employer’s compensation deduction is generally allowed in the taxable year during which (or with

which) the employee’s taxable year ends. In other words, the employee’s tax year is considered first,

and the deduction may be delayed if the employer and employee use different taxable years. Consider

the following examples:

□ If the employer and employee are both calendar-year-end taxpayers, the timing of the employer’s

deduction will generally correspond with the timing of the employee’s recognition of income for

the compensation.

□ If the employer’s tax year ends on August 30, any compensation paid to the employee after

December 31 and before September 1 may cause a one-year delay in the reporting of the

employer’s tax deduction.

Treasury Regulation Section 1.83-6(a)(3) makes a significant exception to this timing rule. The

exception permits the employer to take a deduction in accordance with its method of accounting (cash

or accrual) if the property is substantially vested upon transfer. Typically, most non-qualified stock-

based compensation awards, other than restricted stock, will qualify for this exception and the

deduction will be taken when the employee recognizes income.

Companies that do not have a calendar year-end should familiarize themselves with this regulation

because the timing of recognizing the employer’s tax deduction will impact the recognition of the tax

impacts of the awards in the financial statements.

Companies will recognize windfall tax benefits when the uncertainty about the amount of the

deduction is resolved, which is typically when an award is exercised or expired, in the case of share

options, or vests, in the case of nonvested stock awards, subject to normal income tax valuation

allowance considerations. For example, assume an employer’s fiscal and tax years end on June 30. If a

taxable exercise of a non-qualified stock option occurs on May 1, 20X6 (during the company’s fiscal

year ended June 30, 20X6), the employee will reflect the compensation income in their tax return for

the year ending December 31, 20X6. Any compensation earned by the employee between January 1

and June 30 may not be deductible by the employer until its following fiscal year. Therefore, the

company may not be able to reflect a tax deduction until its June 30, 20X7 tax return, as that is the

company’s tax year that includes the year-end date of the employee’s 20X6 tax year.


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10.7.2 Tax deductions for various types of stock awards

The following section discusses the timing of deductions by employers for restricted stock, restricted

stock units, and stock options.

10.7.2.1 Restricted stock award tax deductions

The timing of the deduction for restricted stock awards will typically correspond with the employee’s

recognition of income under IRC Section 83(a). Because restricted stock shares are not fully vested

upon transfer, the employer’s deduction is subject to the general timing rule under Treasury

Regulation Section 1.83-6(a)(1). Thus, the employer’s deduction is taken in its tax year in which the

employee’s tax year ends. This guidance assumes that the compensation will have been included, or

deemed to have been included, in the employee’s gross income due to the employer’s timely reporting.

If the employee makes an IRC Section 83(b) election (which accelerates the employee’s income

recognition), the employer is allowed to take the tax deduction in the year that the employee reports

the compensation in gross income. If the amount of compensation that the employee recognized is not

properly reported for tax purposes on the employee’s Form W-2 (or the independent contractor’s

Form 1099-MISC), the employer will not be able to claim its deduction unless it can prove that the

employee properly recognized the amount as compensation.

10.7.2.2 Restricted stock unit tax deductions

Similar to restricted stock awards, the timing of the deduction for RSUs will correspond with the

employee’s recognition of income upon vesting. However, because most RSU shares are fully vested

upon transfer, the employer’s tax deduction is generally taken under the special timing rule under

Treasury Regulation Section 1.83-6(a)(3). Therefore, to the extent that the RSU income is timely

reported by the company on the employee’s Form W-2 (or the independent contractor’s Form 1099-

MISC), the employer may take a deduction in accordance with its method of accounting in the year the

vested shares are transferred. Because an RSU is a promise to deliver shares to the employee in the

future and does not represent an actual property interest, it is not until the shares are both vested and

transferred (as sometimes the share transfer is delayed by the employer) that the employee will have

taxable compensation and the employer is eligible to claim a tax deduction.

10.7.2.3 Nonqualified stock option tax deductions

Nonqualified stock options are not treated as property on the grant date for purposes of IRC Section

83, unless the option is in the uncommon position of having a readily ascertainable fair market value

at that time. The grant of a nonqualified stock option to an employee is generally not reported on the

employee’s tax return. Instead, the compensation event occurs when the options are exercised and the

underlying stock is delivered, at which time the employee is taxed. If the employee receives vested

shares upon exercising the option, the employer is entitled to a tax deduction at the time of exercise.

The timing of the deduction will be determined under Treasury Regulation Section 1.83-6(a)(3), which

permits the employer to take a deduction in accordance with its method of tax accounting. If, however,

the shares delivered upon exercise are not substantially vested and if the employee does not make an

83(b) election, the employee’s taxation is delayed under IRC Section 83(a), and the employer would

take its deduction under the general rule of Treasury Regulation Section 1.83-6(a)(1).


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10.7.2.4 Statutory stock option tax deductions

If the employer has granted statutory stock options (e.g., ISOs or ESPPs), it will receive a tax

deduction only upon a disqualifying disposition. If there is a disqualifying disposition, the employer

will be entitled to a tax deduction if (1) the employee recognizes ordinary income at the time of sale

and (2) the employer reports the income. An employer that otherwise satisfies the requirements of IRC

Section 6041 will be regarded as having fulfilled those requirements in a timely manner if the

employer gives the employee a Form W-2 or Form W-2(c) (as appropriate), and files the form with the

IRS by the date that the employer files the tax return that claims the deduction related to the

disqualifying disposition.

Many companies allow employees to transfer their shares to personal brokerage accounts. When that

occurs, companies may lose the ability to track disqualifying dispositions and corporate tax deductions

may be lost. Companies that continue to grant ISOs might consider requiring that shares be held with

a specified broker during the holding period, requesting annual self-reporting by employees, or

legending the stock (which is a restriction that prevents the shares from being sold or transferred until

approved by the company) to prevent sales without notification to the company.

10.8 Limitations on stock-based compensation tax deductions

The following section summarizes some of the key corporate income tax considerations related to





10.8.1 IRC Section 162(m) limitation

The tax deduction that an employer is eligible for under IRC Section 83(h) may be subject to certain

limitations. One limitation is the million-dollar limitation, which was established by IRC Section

162(m). IRC Section 162(m) provides that for public companies, the annual compensation that may be

deducted in a year with respect to covered employees is limited to $1 million per covered employee.

Prior to the 2017 tax law changes, certain performance-based compensation was exempt from this

limitation. That exception may still be applied to remuneration paid under a written binding

agreement that was in effect on November 2, 2017 and has not been materially modified. There was

previously an exemption under the IPO transition rules for newly public companies, which was

eliminated in 2020.

All individuals who hold the position of either chief executive officer or chief financial officer at any

time during the taxable year are covered employees. Covered employees also include the company’s

three other most highly compensated officers, pursuant to the SEC’s rules for executive compensation

disclosures in the annual proxy statement. Any individual who is deemed a covered employee will

continue to be a covered employee for all subsequent taxable years, including years after the death of

the individual. The anticipated effect of the Section 162(m) limitation should be considered, using one

of three methods, when recognizing deferred tax assets for awards that may be subject to the

limitation. The selection of a method should be treated as the election of an accounting policy and

should be applied consistently. We believe any of the following approaches would be acceptable for


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determining whether a deferred tax asset should be recorded for stock-based compensation that is

subject to the IRC Section 162(m) limitation:

□ The impact of future cash compensation takes priority over stock-based compensation awards. In

other words, if the anticipated cash compensation is equal to or greater than the total tax

deductible annual compensation amount ($1 million) for the covered employee, a company would

not record a deferred tax asset associated with any stock-based compensation cost for that

individual.

□ The impact of the stock-based compensation takes priority over future cash compensation. In

other words, a deferred tax asset would be recorded for the stock-based compensation up to the

tax deductible amount.

□ Prorate the anticipated benefit between cash compensation and stock-based compensation and

reflect the deferred tax asset for the stock-based compensation award based on a blended tax rate

that considers the anticipated future limitation in the year such temporary difference is expected

to reverse.

10.8.2 Golden parachute rules

In addition to the IRC Section 162(m) limitation, the tax deduction for stock-based compensation may

also be limited by the golden parachute rules under IRC Section 280G. IRC Section 280G(a) provides

that an employer is not allowed to take a deduction for an excess parachute payment. An excess

parachute payment is any payment that serves as compensation to (or that is for the benefit of) a

disqualified individual and:

□ is contingent on (1) a change in ownership or effective control of the corporation, or (2) a change

in ownership of a substantial portion of the corporation’s assets; and

□ has an aggregate present value that equals or exceeds an amount that is three times the base

amount.

Treasury Regulation Section 1.280G-1 specifies that certain compensation payments can be excluded

from the definition of parachute payments. Some forms of stock-based compensation may qualify for

this exception, such as reasonable compensation for services that are actually rendered after a change

of control; payment from certain privately held companies; payment from qualified plans; and

payments made by a small-business corporation.

To determine the IRC Section 280G value of stock options, taxpayers must use an option valuation

model, such as Black-Scholes, to determine the parachute value of a stock option where vesting is

accelerated upon a change of control. To accurately track the corporate tax deduction related to stock

options with parachute value, companies may need to establish a separate tracking mechanism for the

time these options remain outstanding following the change of control.

10.9 Awards to employees of non-US subsidiaries

Stock-based compensation that is granted to the employees of a US company’s non-US subsidiaries

will generally not result in a US federal income tax deduction for the parent company. There are two

specific considerations to address in this area:


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□ Under IRC Section 83(h), the tax deduction is granted only to the employer for whom the services

were performed. If the non-US employee provides services only to the non-US subsidiary and such

services benefit only the non-US subsidiary’s business operations, the US parent company will not

be entitled to a tax deduction for such awards.

□ In certain countries, the non-US subsidiary may be entitled to a corporate tax deduction that can

be calculated in the same manner as the US deduction. In many jurisdictions, the non-US

subsidiary must bear the cost of the award in order to be eligible for a local corporate-tax

deduction. By charging the award’s cost to the non-US subsidiary, the consolidated company may

be able to lower its overall corporate-tax expense and repatriate cash to the United States. If costs

are recharged to the non-US subsidiary, the recharge of stock-based compensation costs to the

non-US subsidiaries in return for cash (1) should be treated as the company’s issuance of capital

stock in exchange for cash or property and (2) should not result in the issuing company’s

recording a taxable gain or loss on the transaction. According to IRC Section 1032(a) and Treasury

Regulation Section 1.1032-1(a), the US parent company would be allowed to receive cash

payments from its non-US subsidiaries in exchange for its stock and would not be required to

record for tax purposes any income, gain, or loss related to such arrangement.

Before implementing a recharge agreement in a given jurisdiction for purposes of claiming a local

corporate tax deduction, multinational companies should review the tax laws of each jurisdiction to

ensure that foreign exchange, social tax, or treasury share issues will not limit or prohibit the recharge.

Companies should also consider the impact of a recharge arrangement on the new global intangible

low-taxed income (GILTI) and base erosion and anti-abuse (BEAT) taxes, which may be favorable or

negative depending on each company’s specific facts and circumstances. There may be a number of

recordkeeping issues with such recharge agreements to ensure that costs are appropriately charged to

the correct local entity and that employee income tax withholdings have been determined

appropriately. Additionally, companies should consider whether statutory accounting requirements

may impact the timing or amount of the deduction. For example, an amendment to IFRS 2 provides

guidance on the accounting for stock-based compensation in subsidiary financial statements. This

guidance may impact the timing and amount of a corporate tax deduction in certain jurisdictions.

Companies should consider consultation with local accounting and tax advisors to determine how the

different requirements interact.

10.10 Summary of IRC Section 409A

IRC Section 409A determines when an employee is taxed for stock-based compensation awards (see

SC 10.2.6, SC 10.6.3, SC 10.6.4, and SC 10.6.5). Section 409A provides a broad definition of

nonqualified deferred compensation and provides rules related to the timing of elections and

distributions under deferred compensation arrangements. In addition to affecting deferrals of cash

compensation, IRC Section 409A has significant implications for stock-based compensation plans.

While Section 409A includes a very broad definition of nonqualified deferred compensation, the

regulations confirm that ISOs, qualified ESPPs, and restricted stock awards (but not restricted stock

units) are specifically exempt from the provisions of IRC Section 409A. In addition, the regulations

provide that nonqualified options are not deferred compensation and are not subject to Section 409A

if:

□ The option is over “service recipient stock;”


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□ The exercise price of the option can never be less than the fair market value of the underlying stock

on the grant date;

□ The receipt, transfer, or exercise of the option is subject to taxation under IRC Section 83; and

□ The option does not include any deferral feature other than deferral of income from the grant date

until the option exercise date.

Options with a floating exercise price that could be less than the fair market value of the stock on the

grant date will be treated as deferred compensation under Section 409A. Further, the payment of a

dividend equivalent contingent upon the exercise of the option will be treated as a reduction in the

exercise price causing the option to be deferred compensation under Section 409A. Companies should

review their plans to ensure that the exercise price and dividend equivalent rights meet the

requirements under Section 409A.

The regulations include a similar exception for both cash- and stock-settled SAR plans.

In order for both nonqualified stock options and SARs to be exempt from Section 409A, the award

must be over “service recipient stock.” Generally, a stock right may cover common stock of the

employing company or another company directly up the corporate chain. The rules regarding service

recipient stock are complex and should be carefully examined in each individual circumstance. The

regulations provide that service recipient stock is any class of stock that is common stock for the

purposes of IRC Section 305. Any class of common stock may be used, even if another class of service

recipient stock is publicly traded or has a higher aggregate value outstanding, provided that the

common stock does not have a preference to distributions and cannot be subject to mandatory

repurchase (other than a right of first refusal) or a put or call right that is not a lapse restriction, unless

the price paid is the current fair market value on the repurchase event. An American Depository

Receipt or American Depository Share, to the extent that the stock is traded on a foreign exchange,

continues to qualify as service recipient stock.

Other stock-based compensation grants may be exempt from IRC Section 409A if the compensation is

paid during the “short-term deferral period.” The Treasury Regulations provide an exclusion to

Section 409A for compensation that is paid in the year of vesting or no later than 2 1/2 months after

the end of the later of the employer’s tax year or the employee’s tax year in which vesting occurs. Thus,

for example, an RSU that transfers the stock in the year of vesting is generally excluded from Section

409A.

Stock-based compensation awards that do not fall within the exceptions are generally subject to the

requirements of IRC Section 409A. Section 409A imposes restrictions on the timing and form of

deferral elections, the timing of distributions/payments and the use of certain trusts to fund the

arrangements. If these requirements are not met, the individual is subject to accelerated taxation,

enhanced underpayment interest, and an additional 20% tax.

Chapter 11: Employee stock ownership plans (ESOPs)

Employee stock ownership plans (ESOPs)

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11.1 Employee stock ownership plans (ESOPs) chapter overview

This chapter provides an overview of employee stock ownership plans (ESOPs) as well as questions

and interpretive responses to specific aspects of presentation and recognition. The guidance for ESOPs

is located in ASC 718-40. This chapter includes some supplemental and interpretative guidance, but

does not include the entirety of the accounting framework contained in ASC 718-40.

AICPA Statement of Position (SOP) No. 76-3, Accounting Practices for Certain Employee Stock

Ownership Plans, was the principal source of guidance before the issuance of SOP 93-6, Employers’

Accounting for Employee Stock Ownership Plans,” which is now codified in ASC 718-40. The

guidance of SOP 76-3 was not carried forward to the FASB Accounting Standards Codification, but

under the original transition provisions of SOP 93-6, employers could elect to continue to account for

shares acquired by an ESOP on or before December 31, 1992 under SOP 76-3. We have not included

detailed guidance under SOP 76-3 in this guide, but information can be found in SOP 76-3. The

following EITF consensuses also provide further interpretive guidance on the application of SOP 76-3:

□ EITF 89-10, Sponsor’s Recognition of Employee Stock Ownership Plan Debt

□ EITF 89-8, Expense Recognition for Employee Stock Ownership Plans

□ EITF 87-23, Book Value Stock Purchase Plans

The key difference between the guidance in ASC 718-40 and SOP 76-3 is that compensation cost

recognized under SOP 76-3 is based on the historical purchase cost of the shares rather than the fair

value of the shares at the time they are allocated to employees.

11.2 Overview of ESOP plans

An employee stock ownership plan is a qualified stock bonus plan, or a combination stock bonus and

money purchase pension plan (essentially a defined contribution plan), that is designed to invest

primarily in employer stock, and that meets the requirements of the Employee Retirement Income

Security Act of 1974 and the Internal Revenue Code of 1986.

ESOPs are established for many reasons, including (1) to provide employees compensation and an

ownership stake in the company, (2) as a form of takeover protection, (3) as a financing vehicle, (4) as

a means to take a company private, (5) to transition ownership from a single owner or a group of

owners (i.e., an exit strategy), or (6) to realize available tax incentives. In addition to the tax

advantages provided by other employee benefit plans, ESOPs may enable employers and others to

qualify for the following, if specific requirements are met:

□ Contributions to an ESOP that are used to repay loans incurred to purchase employer securities

may be deducted if they do not exceed 25% of the compensation paid to participants.

□ Contributions to an ESOP that are used to pay the interest on the ESOP loan may not be subject to

the 25%-of-compensation limit.


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□ Certain dividends on employer stock held by an ESOP may be deductible by the employer for tax

purposes if the dividends are:

o paid to ESOP participants,

o used to repay the ESOP loan, or

o at the election of the participant, either distributed to the participant or reinvested in

employer stock.

□ An individual who sells shares of a C-corporation to the ESOP may be able to defer the recognition

of the taxable gain on the sale of the shares, if certain requirements are met.

An ESOP may purchase the employer's shares from an existing shareholder, the employer’s unissued

shares or shares held in treasury, or shares outstanding in the public equity market, or may also

purchase the employer's debt securities. Alternatively, new classes of capital stock are frequently

created specifically for ESOPs. See SC 11.3.3.

Shares issued to the ESOP are allocated by the ESOP trustee to plan participants in accordance with

the plan agreement. Shares are allocated to individual employees even though they may not vest for a

period of time and will not be distributed to them until retirement or termination.

Some companies' bylaws prohibit non-employees from owning employer stock, thereby requiring

participants to sell their shares back to the ESOP or the company upon termination of employment or

retirement. Large publicly-traded companies typically do not require participants to sell their shares

upon leaving the company.

At a high level, a typical ESOP is just another way to provide compensation to employees in the form of

employer stock. Depending on the specific terms of the ESOP, including when and how shares are

allocated to individual participants, the amount and timing of recognition of compensation expense

may vary, but the basic principle is that compensation expense will be recognized for the value of the

shares awarded to the employee over the requisite service period.

11.3 Types of ESOPs

There are four types of employee stock ownership plans: (1) nonleveraged ESOPS (see SC 11.3.1), (2)

leveraged ESOPS (see SC 11.3.2), (3) convertible preferred stock with a put option (see SC 11.3.3), and

(4) convertible preferred stock with guaranteed redemption (see SC 11.3.4).

11.3.1 Nonleveraged ESOPs

In a nonleveraged employee stock ownership plan, the employer contributes cash to the ESOP, which

is used by the ESOP to purchase the employer's stock, or the employer contributes its stock directly to

the ESOP. This type of ESOP is essentially a defined contribution plan, or part of a defined

contribution plan. An employer’s accounting for contributions to a defined contribution plan and the

related compensation cost to be recognized are specified in ASC 715-70. ASC 718-40, Employee Stock

Ownership Plans, also contains guidance for nonleveraged ESOPs (see SC 11.4.1).

Many employers have established nonleveraged ESOPs within their 401(k) plans when employer stock

is offered as an investment option to participants or there is or was a company contribution of


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employer stock. The funds in these 401(k) plans held in company stock can be converted to

nonleveraged ESOPs within the plan to take advantage of the dividend deduction opportunity, as

described in SC 11.2.

11.3.2 Leveraged ESOPs

In a leveraged employee stock ownership plan, the ESOP borrows funds from a bank or other lender.

The employer that sponsors the ESOP generally guarantees the loan or otherwise commits, directly or

indirectly, to make contributions, pay dividends, or both to the ESOP. Alternatively, the employer may

make a loan to the ESOP without any external financing. Employer contributions to the ESOP and, in

most instances, dividends on the employer’s stock held by the ESOP, are used by the ESOP to service

the debt, whether with a third party or with the sponsor. In cases when there is a third-party lender, it

is common for the third-party lender to provide a loan to the employer, and for the employer to make a

loan to the ESOP.

11.3.2.1 Debt terms and share allocation of a leveraged ESOP

Some leveraged employee stock ownership plan borrowings have terms that require level repayment of

the debt over a period of years. Alternatively, the repayment schedule for the ESOP loan could depend

on the employer’s expected cash flow or expected compensation costs. Loans may be structured to

require only interest payments for a number of years or may permit negative amortization of the

principal amount. Debt agreements may also require prepayments of debt if the employer’s cash flow

exceeds certain thresholds or may permit voluntary prepayments by the employer. Shares issued to the

ESOP may be allocated to participants (employees) based on principal payments or principal and

interest payments, depending on the particular ESOP plan and IRS regulations. In cases when there is

a loan from a third party to the employer with a corresponding loan from the employer to the ESOP,

the outside loan from the third party is frequently repaid more rapidly than the loan from the

employer to the ESOP. The repayment of the loan to the ESOP (from the employer in these cases)

triggers the release and allocation of shares to participants in the ESOP.

11.3.2.2 Dividends paid on shares held in a leveraged ESOP

Some leveraged employee stock ownership plans are structured so that much of the amount necessary

to service the debt comes from dividends paid on the shares of stock held by the ESOP. Dividends on

allocated shares—i.e., essentially shares that are deemed to be owned by the employees—are not

treated as compensation expense but are charged by the employer directly to retained earnings. For

this reason, some preferred stocks issued to leveraged ESOPs pay dividends at rates that may be

higher than the dividend rates for similar securities.

ASC 718-40-25-16 requires employers to account for dividends on unallocated shares as a payment of

debt or accrued interest (if the dividends are used to pay debt service) or as compensation cost (if the

dividends are paid to participants or added to their accounts) (see SC 11.4.2).

Pursuant to ASC 718-740-45-8, the tax benefit of tax-deductible dividends on allocated and

unallocated employee stock ownership plan shares should be recognized as a component of income tax

expense. See TX 17.


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11.3.2.3 Cash flow impact of payments on leveraged ESOP debt

Payments made on principal balances of outstanding employee stock ownership plan loans obtained

from outside lenders that are funded through contributions (either cash or as dividends) from the

employer should be reflected as financing cash outflows. Under ASC 718-40, the employer that

sponsors the ESOP effectively consolidates the ESOP, reflecting both the loan and the cost basis of the

shares held by the ESOP on the employer's balance sheet. ASC 718-40-25-9 indicates that employers

should accrue interest cost on the debt, and should report cash payments to the ESOP that are used by

the ESOP to service debt (regardless of whether the source of cash is employer contributions or

dividends) as reductions of the debt and accrued interest payable when the ESOP makes payments to

the outside lender. As the contributions are reflected as reductions of the debt and accrued interest

balances, the cash flows associated with paying down the principal balance of the debt should be

reported by the employer as financing cash outflows (FSP 6.7.2). The payments associated with

interest should be reflected as operating cash outflows.

11.3.3 Convertible preferred stock with a put option in an ESOP

Some companies have issued a class of convertible preferred stock (rather than common stock) to an

employee stock ownership plan due to, among other things, the additional flexibility this allows with

respect to dividends and the potential for mitigating the earnings per share dilution impact from ESOP

shares.

An ESOP may purchase employer securities in the form of convertible preferred stock that is not

readily tradeable on an established market. Under federal income tax regulations, employer securities

held by ESOP participants that are not readily tradeable must include a put option. The put option

gives participants the right to demand that the employer redeem shares of employer stock held by the

participant for which there is no market at a price determined by a fair valuation formula. The

employer may have the option to issue other of its marketable debt or equity securities for all or a

portion of the put option rather than pay cash. In some cases, the provisions of the ESOP may permit

the ESOP to buy the employer’s stock under the put option instead of the employer buying it back;

however, in no case can the employer require the ESOP to assume the obligation for the put option.

In ESOPs when the employee has the option to put the preferred stock to the ESOP trustee for cash or

employer common stock, the ESOP trustee would have the right to put the preferred stock back to the

employer. In certain plans, the employer may be required to satisfy the put with common stock only,

and the ESOP would then sell the common stock in the open market for cash, which it would use to

satisfy the employee request for cash.

ASC 480, Distinguishing Liabilities from Equity, establishes standards for how an issuer should

classify and measure certain financial instruments with characteristics of both liabilities and equity.

The guidance in ASC 480 is required to be followed for freestanding financial instruments (as defined

in the standard) issued in connection with an ESOP only if they are no longer subject to ASC 718-40 or

related guidance. Until that occurs, the instruments would be outside the scope of ASC 480. ASC 480-

10-15-8 states that ESOP shares or freestanding agreements to repurchase these shares are not within

the scope of ASC 480 because those shares are accounted for under ASC 718-40 or its related guidance

through the point of redemption.

Thus, these hybrid securities must be analyzed to determine whether any of the embedded derivative

features need to be bifurcated under ASC 815, Derivatives and Hedging. ASC 815-15-25 requires that

the terms of a convertible preferred stock, excluding the conversion option, be assessed to determine if


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the host is more debt-like or equity-like. A conclusion that the host is more debt-like would require

further evaluation of the security to determine whether the embedded derivative should be bifurcated.

If the security contains any options (whether they are puts, calls, or conversion options, and whether

they are contingent or not), the options should be evaluated under ASC 815. Refer to FG 1.6 for

additional information.

11.3.4 Convertible preferred stock with guaranteed redemption

An employer may issue a convertible preferred stock to an employee stock ownership plan that is

redeemable by the employer at a redemption price equal to the initial value established for the

preferred stock. Redemption may be satisfied in common stock, cash, or a combination of both.

Alternatively, each share of the preferred stock could be convertible into a fixed number of shares of

common stock.

11.4 Accounting for ESOPs

ASC 718-40 applies to all employee stock ownership plans, including those used to settle or fund

liabilities for specified employee benefits, such as an employer's 401(k) plan matching contribution.

11.4.1 Accounting for nonleveraged ESOPs

Under ASC 718-40, employers that sponsor a nonleveraged ESOP should account for the arrangement

as follows:

□ Employers should report compensation cost equal to the contribution called for in the period

under the plan.

□ The shares contributed or acquired with the cash contributed should be allocated to participant

accounts as of the end of the employee stock ownership plan's fiscal year and held by the ESOP

until distributed to the employees at a future date, such as on the date of termination or

retirement.

□ Employers should generally charge dividends on shares held by the ESOP to retained earnings as

described in ASC 718-40-25-20.

11.4.2 Accounting for leveraged ESOPs

Under ASC 718-40, employers that sponsor a leveraged ESOP should account for the arrangement as

follows:

□ The issuance of new shares or the sale of treasury shares to the employee stock ownership plan

should be recorded when the issuance or sale occurs, and should report a corresponding charge to

unearned ESOP shares, a contra-equity account.

□ Employers should recognize compensation cost equal to the fair value of the shares for those ESOP

shares committed to be released to compensate employees directly.

ASC 718-40 uses the concept of "committed to be released" shares, which are "shares that,

although not legally released, will be released by a future scheduled and committed debt service

payment and will be allocated to employees for service rendered in the current accounting period."


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The legal release of shares generally does not occur until debt payments are made, but employee

service to which the shares relate is continuous.

ASC 718-40 notes that the period of service to which the shares relate is generally defined in the

ESOP documents. The shares are deemed to be committed to be released ratably during the

accounting period as the employees perform services, and, accordingly, average fair values are

used to determine the amount of compensation cost to recognize each reporting period.

□ For ESOP shares used to settle or fund liabilities for other employee benefits, employers should

report satisfaction of the liabilities when the shares are committed to be released. Compensation

cost and liabilities associated with such benefits should be recognized in the same manner as they

would if an ESOP had not been used to fund the benefit.

□ Employers should charge dividends on allocated and committed to be released shares to retained

earnings; dividends on unallocated shares should be treated as a payment of debt or accrued

interest or as compensation cost, depending on whether the dividends are used for debt service or

paid to participants.

□ For ESOP shares committed to be released that are designated to replace dividends on allocated

shares used for debt service, employers should report the satisfaction of the liability to pay

dividends when the shares are committed to be released for that purpose.

□ Employers should credit the contra-equity account “unearned ESOP shares” as the shares are

committed to be released, based on the original cost of the shares to the ESOP. The difference

between the amount reported for compensation expense (the fair value of the shares committed to

be released) and the amount credited to the contra-equity account (i.e., the cost of the shares to

the ESOP) should be charged or credited to shareholders' equity in the same manner as gains and

losses on sales of treasury stock (see ASC 505-30-30-5 through ASC 505-30-30-10).

□ Employers should report redemptions of ESOP shares as purchases of treasury stock.

□ Employers should report loans from outside lenders to their ESOPs as liabilities on the balance

sheet and should report the related interest cost on the debt. Employers with internally leveraged

ESOPs should not report the loan receivable from the ESOP as an asset and should not report the

ESOP's debt from the employer as a liability, or recognize interest income or cost on the employer

loan.

11.4.2.1 Recognition upon termination of an ESOP

ASC 718-40-40-7 states that the release of remaining suspense shares to participants upon

termination of an employee stock ownership plan results in a charge to compensation in accordance

with ASC 718-40-25-11 through ASC 718-40-25-14. It further states "compensation cost should equal

the fair value of the shares at the date the ESOP debt is extinguished because that is when the shares

are committed to be released."

However, ASC 718-40 defines "committed to be released shares" as "the shares that, although not

legally released, will be released by a future scheduled and committed debt service payment." This

definition implies that shares may be committed to be released prior to the extinguishment of ESOP

debt and, therefore, a compensation charge could be recorded prior to the date of the debt


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extinguishment (i.e., at the time the shares are committed to be released in accordance with ASC 718-

40-25-12).

As the definition in ASC 718-40 of "committed to be released shares" addresses situations other than

termination of the ESOP, the guidance in ASC 718-40-40-7 should be followed only when accounting

for a termination of an ESOP. In all other cases, the guidance in ASC 718-40-25-12 should be followed.

11.4.3 Commitments to make future contributions to an ESOP

Employers typically make cash contributions to employee stock ownership plans, either to fund debt

service for a leveraged plan or to purchase shares that will be allocated to participants' accounts in the

current fiscal period for a nonleveraged plan. On occasion, an employer may commit to make

additional contributions to the ESOP (either leveraged or nonleveraged) in the future to purchase

additional shares of the entity's stock, which will be allocated to the participant accounts of those

employees providing service in the year the contributions are made. This may be the result, for

example, of consideration for the plan trustees agreeing to extend the terms of an ESOP loan. Under

ASC 718-40-25-13, compensation expense should only be recognized when the shares are committed

to be released to participants, the definition of which includes allocation to employees providing

service in the current accounting period, not just the commitment to make a cash payment. In this

case, no expense should be recognized in the current year. It is the commitment to release shares

based on service in the current accounting period, not the employer's cash contribution or

commitment to make a future contribution, which represents the economic transfer of compensation

to participants in exchange for service.

As noted in ASC 718-40-25-3 through ASC 718-40-25-6, if the employer decides to make an additional

stock contribution and those shares are unallocated until some future date, the entity should report

the share issuance as a reduction of shareholders' equity, as if they were treasury stock with a

corresponding charge to unearned employee stock ownership plan shares (contra-equity). As such,

until there is a commitment to release and allocate the shares to participant accounts, no

compensation expense should be recorded. This is consistent for both leveraged and nonleveraged

ESOPs.

Additionally, the balance sheet should not reflect a liability to the ESOP for a commitment by the

employer to contribute additional consideration to the ESOP in the future nor a receivable by the

ESOP for the employer’s commitment. In ESOP accounting, an entity typically eliminates transactions

between the employer and the ESOP, and accounts for only external transactions. This is described in

ASC 718-40-25-9(b), which explicitly calls for the elimination of any loans between the employer and

the ESOP, as well as ASC 718-40-40-3, which states that, if the employer makes a contribution to the

ESOP or pays dividends on unallocated shares that are used by the ESOP to repay the debt, the

employer should charge the debt and accrued interest payable only when the ESOP makes the

payment to the outside lender. As a contractual loan between the employer and ESOP plan is

eliminated and not reflected as a payable by the employer, we similarly do not believe that the

employer should reflect a commitment (even if legally binding) to make additional cash contributions

to the ESOP plan in the future in exchange for future service as a liability.


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11.5 Questions and interpretive responses specific to ESOPs

The following are questions and interpretive responses specific to employee stock ownership plan

accounting and presentation.

11.5.1 Balance sheet presentation of ESOPs

Question SC 11-1 addresses the classification of shares held by an ESOP that are classified outside of

permanent equity.

Question SC 11-1

For a leveraged employee stock ownership plan when the stock purchased by the ESOP is classified outside of permanent equity, how should the ESOP’s investment in those shares be classified in the sponsor’s consolidated balance sheet?

PwC response

Pursuant to ASC 480-10-S99-4, when some or all of the recorded amount of the securities held by the

ESOP are required to be classified outside of permanent equity (see FG 7.4.3.2), a proportional

amount of the "unearned ESOP shares" contra-equity account should be classified in the same

manner.

The contra account could either be presented as a separate line item or could directly reduce the

recorded securities amount, provided there is adequate disclosure describing the netting.

Question SC 11-2 addresses the reporting by a parent and its subsidiary in the separate financial

statements of a subsidiary borrowing to fund an internally leveraged ESOP.

Question SC 11-2

In reporting of ESOP transactions by a parent, its subsidiary, and the parent’s ESOP, how are the following transaction reported by the ESOP and in the separate company financial statements of the parent and its subsidiary?

□ Subsidiary obtains a third-party loan and lends the borrowed money to the parent.

□ The parent loans the money to the ESOP so it can purchase stock of the parent.

PwC response

The third-party loan obtained by the subsidiary should be accounted for as a loan payable by the

subsidiary to the third party. This would be reflected in the consolidated financial statements.

The intercompany loan between the subsidiary and the parent should be accounted for as a loan to the

parent by the subsidiary and a loan payable to the subsidiary by the parent. This loan would be

eliminated in the consolidated financial statements.


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The parent would account for the cash paid to the ESOP as a loan to the ESOP. The ESOP should

account for the cash received as a loan from the parent. This loan would eliminate in the consolidated

financial statements.

The ESOP should account for the purchase of the parent stock as an investment in the parent. The

parent would report the issuance of the shares as an increase to equity. In the consolidated financial

statements, the ESOP’s investment in the parent’s stock would be reclassified to a contra-equity

account referred to as unearned ESOP shares.

Question SC 11-3 addresses the accounting for convertible stock with a put option or that is subject to

redemption by the sponsor of an ESOP.

Question SC 11-3

Under what circumstances should all or a portion of stock with a put option or a mandatory cash redemption feature held by an ESOP (see SC 11.3.3) be classified outside of permanent equity in the sponsor's balance sheet?

PwC response

ASC 480-10-S99-4 provides the SEC staff’s interpretation requiring classification outside of

permanent equity of the maximum possible cash obligation if an equity security contains conditions

(regardless of their probability of occurrence) whereby holders of the security (e.g., ESOP participants,

regardless of whether the underlying shares have been allocated to individual participants) can require

the company to redeem the shares for cash. When the cash obligation relates only to a market value

guarantee feature (i.e., cash feature only for amount by which the "floor" exceeds the common stock

market price as of the reporting date), this guidance requires only the cash portion of the obligation to

be classified outside of permanent equity. While this guidance is only applicable to public companies,

we believe the interpretation of whether classification outside of permanent equity is appropriate for

instruments subject to redemption based on conditions outside the control of the issuer is generally

also appropriate for private companies.

11.5.2 Profit and loss of ESOPs

Question SC 11-4 addresses the reporting by a parent and its subsidiaries of committing shares to be

released in an ESOP.

Question SC 11-4

A parent has two subsidiaries (Subsidiaries A and B) whose employees are participants in the ESOP. How are shares committed to be released reported by the ESOP and in the separate company financial statements of the parent and its subsidiaries?

PwC response

As the ESOP shares are committed to be released, the parent would recognize compensation cost, or

reduce dividends payable or an accrued compensation liability, depending on the purpose for which

the shares are being released. The amount should be measured at the current fair value of the shares

committed to be released. The parent would reflect the commitment to release the shares as a


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reduction of the unearned ESOP shares contra-equity balance. Subsidiaries A and B should record this

as a charge to compensation expense for their employees’ portion of the shares committed to be

released with a corresponding credit to additional paid-in capital consistent with the guidance in ASC

718-10-15-4 for share-based payments to an employee by a related party or other economic interest

holder. The commitment to release shares is not an accounting event for the ESOP itself, so no entry

would be made by the ESOP for this transaction.

Question SC 11-5 addresses the reporting by a parent and its subsidiary in their separate financial

statements of dividends paid to shares held by an ESOP.

Question SC 11-5

A parent has a subsidiary whose employees are participants in the ESOP. The subsidiary obtains a third-party loan and lends the borrowed money to the parent. The parent then loans the money to the ESOP in order for the ESOP to purchase shares of parent stock. How are dividends paid on the parent’s stock reported by the ESOP and in separate company financial statements of the parent and its subsidiary?

PwC response

The ESOP would report an increase in cash and dividend income for all of the dividends received by

the ESOP. If the dividend payment related to unallocated shares will be used to service the debt, the

ESOP would reduce the balance of its loan (and accrued interest) due to the parent.

The parent would charge the dividend payment to the ESOP as a charge to retained earnings (if the

dividend payment relates to allocated shares), or as a reduction of the loan payable to the subsidiary (if

the dividend relates to unallocated shares) with a corresponding reduction to cash or dividends

payable.

The subsidiary would recognize the cash (received from the parent’s dividend payment via the ESOP,

which pays its loan to the parent, which then in turn pays its loan to the subsidiary) and reduce the

intercompany loan receivable from the parent. If the dividend payment or other payments from the

parent to the ESOP are not sufficient for the subsidiary to service its third-party loan, and the

substance of the arrangement is that the parent will not owe the subsidiary any more than the

subsidiary’s third-party debt, the “additional” debt service funded by the subsidiary should be reflected

as a dividend by the subsidiary to the parent. Accordingly, the subsidiary would charge retained

earnings and reduce the intercompany note receivable from the parent. The parent, in turn, would

reduce the intercompany loan payable to the subsidiary and increase its investment in the subsidiary.

Dividends on unallocated shares paid to participants or added to participant accounts are

compensation expense. Dividends on allocated shares are charged to retained earnings in

consolidation.

Question SC 11-6 addresses the accounting for a repurchase of shares by the employer or by the ESOP

of private company shares at a contractual redemption price that is other than fair value as of that

date.


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Question SC 11-6

A private company has an employee stock ownership plan for all of its employees. The ESOP plan document provides that the company will repurchase participants' interests in their ESOP accounts upon retirement at the fair value of the company's stock as of the end of the ESOP plan year preceding distribution.

On June 30, 20X1, an employee retires when the fair value of the company’s stock is $40. Assume the fair value as of the preceding plan year end was $59 per share. Because of the decline in the fair value of the company's stock, this creates a situation in which the ESOP must repurchase the shares from the retiring employee at a price that is in excess of the fair value of the shares on the date of repurchase. Should the company record compensation expense for the excess of the repurchase price over the fair value of the stock on the date of repurchase?

PwC response

Not in this situation. As noted in ASC 718-40-25-2, employers are required to give a put option to

participants holding ESOP shares that are not readily tradable, which on exercise requires the

employer to repurchase the shares at fair value. However, ASC 718-40 does not specifically address

when this fair value must be determined. In private company ESOPs, a valuation performed by an

outside appraiser as of the preceding year end date is typically used to determine fair value (i.e., the

repurchase price) for such put options exercised in a given year. The legal terms of this plan require

that the repurchase price be set based on the fair value as of the preceding plan year end. The

repurchase of ESOP shares by the company in accordance with those terms is therefore not a

discretionary decision by the company to further compensate the participant. Furthermore, it is not a

provision designed to keep the participants from bearing the normal risks and rewards of share

ownership as a participant in the ESOP plan, but an administrative convenience to facilitate efficient

operation of the plan. As such, no compensation charge would be recorded for the excess of the

repurchase price over the fair value of the stock on the date of repurchase.

Compensation expense for ESOPs is measured at the fair value of the shares when shares are

committed to be released (i.e., as the employees perform the services to which the shares relate) under

ASC 718-40. ASC 718-40-30-2 further states that "The amount of compensation expense recognized in

previous interim periods should not be adjusted for subsequent changes in the fair value of the

shares." Therefore, there is generally no compensation expense to be recorded for the company's

repurchase of retiring individuals' shares. Likewise, if the repurchase price was less than the fair value

of the stock on the date of repurchase, it would also be recorded as a treasury stock repurchase and

there would be no reversal of compensation cost recognized.

Note that this accounting treatment should not necessarily be applied by analogy to other types of

share-based awards. As ESOP shares are subject to the guidance in ASC 718-40 and not ASC 718-10 or

ASC 718-20, they are not, for example, subject to the guidance in ASC 718-10-25-9 regarding the

impact of repurchase features on the classification of a share-based payment award as liability or

equity. Had the repurchase been related to a share-based payment award to an employee outside of an

ESOP, there may be different implications of the repurchase feature at a price other than fair value on

the date of repurchase. See SC 4.8. Similarly, if the terms of the plan, by design, always resulted in a

repurchase of the ESOP shares at a premium, that could result in the recording of additional

compensation cost.


11-12

11.5.3 Tax effects of ESOPs

Question SC 11-7 addresses the accounting for the tax benefit of dividends paid on ESOP shares for

which the employer receives a tax deduction.

Question SC 11-7

How is the tax benefit resulting from any qualifying dividend deduction recorded in the financial statements?

PwC response

The tax benefit of tax-deductible dividends on allocated and unallocated employee stock ownership

plan shares are required to be recognized as a component of income tax expense in the income

statement pursuant to ASC 718-740-45-8.

Question SC 11-8 address the income tax accounting for the difference between the fair value and

historical cost of shares held by a leveraged ESOP.

Question SC 11-8

What is the appropriate application of ASC 740, Income Taxes, for treating differences between the fair value (book expense) and the original cost of employee stock ownership plan shares that are committed to be released for leveraged ESOPs?

PwC response

ASC 740-20-45-11 indicates that the suggested treatment for employee stock options is analogous to

ESOPs. Therefore, if the cost of shares committed to be released differs from the shares' fair value, the

employer should record the tax effect of the difference to the income statement. Temporary differences

that are created based on the timing of expense recognition for income tax and financial reporting

purposes should receive normal deferred tax accounting treatment. ASC 718-40-55 contains examples

that illustrate the accounting for deferred tax effects of ESOP transactions.

11.5.4 Earnings per share implications for shares held by an ESOP

Question SC 11-9 addresses the EPS implication of preferred stock held by an ESOP.

Question SC 11-9

When should convertible preferred stock issued to an employee stock ownership plan impact the computation of earnings per share?

PwC response

As with all convertible securities, the number of additional common shares issuable for convertible

securities should not be considered for purposes of calculating basic earnings per share.


11-13

As described at FSP 7.5.6, all convertible securities have to be evaluated as to their effect on earnings

per share calculations as soon as they are issued. This applies to all shares issued to an ESOP;

however, under ASC 718-40-45-6, shares are not considered outstanding until they are committed to

be released. Therefore, only the number of common shares that would be issued on conversion of the

convertible preferred shares held by an ESOP that have been committed to be released should be

deemed outstanding in the if-converted EPS computations for diluted EPS, and only if the effect is

dilutive.

Question SC 11-10 addresses the EPS implications of dividends paid on convertible preferred stock

held by an ESOP.

Question SC 11-10

The Sponsor has issued convertible preferred stock to the ESOP, which pays dividends at a higher rate than the underlying common stock into which it is convertible. If the sponsor pays dividends on the convertible preferred stock to meet the ESOP's debt service requirements, should net income be reduced in the computation of diluted earnings per share by any additional ESOP contribution that would be required to meet the debt service requirement had the preferred stock actually been converted?

PwC response

Under the if-converted method for EPS purposes, conversion of the preferred stock is assumed as of

the beginning of the period. Thus, the dividends paid on the preferred stock would be added back to

the numerator of the EPS calculation (net income available to common stockholders). However, if the

preferred stock had been converted to common stock, a greater number of common shares would need

to be committed to be released to participants in order to fund the ESOP’s debt service, since the

dividend rate on common stock is lower. That allocation would result in additional compensation

expense. Thus, because the allocation of additional shares to participants is a nondiscretionary

adjustment as a result of the application of the if-converted method, net income available to common

stockholders for purposes of calculating diluted EPS should reflect the additional compensation cost

that would arise from the assumed conversion. See ASC 718-40-45-4 and the illustration in ASC 718-

40-55-21 through ACS 718-40-55-33.

ASC 718-40-45-4

Employers that use dividends on allocated ESOP shares to pay debt service shall adjust earnings

applicable to common shares in the if-converted computation for the difference (net of income taxes)

between the amount of compensation cost reported and the amount of compensation cost that would

have been reported if the allocated shares were converted to common stock at the beginning of the

period.

Question SC 11-11 addresses the application of the treasury stock method to sponsor guarantees of the

market value of shares held by an ESOP.


11-14

Question SC 11-11

If a sponsor guarantees that the employees or trustee will receive common stock with a market value at least equal to a specified amount for the convertible preferred stock, sometimes referred to as the guaranteed floor, for purposes of calculating diluted earnings per share, would shares assumed to be outstanding ever be increased if the market price of the underlying common stock is less than the redemption price for the preferred stock?

PwC response

Under ASC 718-40-45-7, if the sponsor guarantees a stated minimum value per share that is

redeemable in either cash or common stock, and if the value of the shares of common stock issuable is

less than the stated minimum value, in applying the if-converted method the employer should

presume that such a shortfall will be made up with additional shares of common stock. However, that

presumption may be overcome if past experience or a stated policy provides a reasonable basis to

believe that the shortfall will be paid in cash.

In applying the if-converted method, the number of common shares issuable on assumed conversion,

which should be included in the denominator of the diluted EPS calculation, should be the greater of

(a) the shares issuable at the stated conversion rate and (b) the shares issuable if the participants were

to withdraw the shares from their accounts. Shares issuable on assumed withdrawal should be

computed based on the ratio of (a) the average fair value of the convertible stock or, if greater, the

stated minimum value to (b) the average fair value of the common stock. The appropriate ratio should

then be applied to the shares issuable at the stated conversion rate to determine the number of shares

issuable on assumed withdrawal.

Question SC 11-12 addresses the EPS implications of a sponsor guarantee of the market value of the

shares held by an ESOP that must be settled in cash.

Question SC 11-12

If the sponsor is required to satisfy the guaranteed floor feature in cash, should interest be imputed or the reverse treasury stock method applied as a result of such assumed cash payment?

PwC response

ASC 718-40 does not address this question. In our view, the liability to satisfy the guaranteed floor

feature is conceptually no different from any other liability of the sponsor. Therefore, the effect of

funding the assumed payment should not be considered (i.e., net income need not be reduced to

reflect a reduction in interest income or an increase in interest expense as a result of the assumed use

of cash to satisfy the guaranteed floor feature). Similarly, it should not be assumed that additional

shares would be issued to fund the cash payment (i.e., the reverse treasury stock method).

Documents

Stock compensation 2020,Stock-based compensation